Understanding Proof-of-Work vs. Proof-of-Stake in Crypto
If you have been in the cryptocurrency ecosystem for a while, terms like Proof-of-Work (PoW) and Proof-of-Stake (PoS) shouldn’t be foreign to you, or you should have at least heard of them.
In this article, I’ll attempt to explain, in plain simple English, what these terms are and what are the main differences between Proof-of-Work and Proof-of-Stake.
Also in this article, I’ll try to answer questions like:
- What staking is,
- How is staking different from mining,
- Can it potentially yield passive income for crypto-traders? and
- What and how do you get started with coin-staking.
First, let’s talk about Mining
Before we tackle what staking is, it is essential to understand why staking is created, and what is its purpose i.e – What does staking aim to solve?
To make the explanation easy, let’s use the example of Bitcoin.
Crypto exchange vector created by jcomp – www.freepik.com
Bitcoin, and some of the earlier (decentralized) cryptocurrencies, allow money to be sent from one party to another, digitally, without any central agency or authority.
Initially, the solution to managing a blockchain was done through mining. Bitcoin mining simply means that miners compete against each other using powerful computers trying to guess the solution to some mathematical question. Whoever finds the solution first will earn the right to write the transaction (also known as the Block) into the ledger.
Mining favors miners with a powerful computer system; with more computing power, one will be able to make more guesses/sec, thus increasing his chances of getting the solution, which then gives him the right to write into the ledger.
Mining is also known as Proof-of-Work (PoW)
As mentioned above, Mining is the process where miners use their computing power and put in a lot of work to try to solve mathematical problems, so they get to write into the ledger/blockchain.
In more technical terms, it is also known as Proof-of-Work (PoW).
Proof-of-Work is a consensus mechanism where the design is to create an agreement as to who gets to update the ledger amongst groups of people/miners (who don’t know each other).
Mining’s drawbacks
While Proof-of-Work seems like a reliable, secure, and legit solution to manage a decentralized ledger, it is also a very resource-intensive one.
As you can see, acquiring high-performance computers can easily break the bank. Also, keeping them running 24/7 just to solve mining’s mathematical problems can easily rack up miners’ electricity bills.
Staking is here to solve Mining’s problems
For the disadvantages of Mining mentioned above, an alternative consensus mechanism – Staking – has been introduced.
Unlike the Mining method, where miners mine with computers to win the contest, Staking lets the users (no longer miners) stake their actual coins in order to win the contest.
Staking is also known as Proof-of-Stake (PoS)
So, how does staking work?
Basically, you lock a certain amount of your coins (or funds) on a Node (your everyday-use computer that is connected to the Internet). The locked funds are considered your stake, and with your stake in place, you are now part of the contest in which the node will get to forge the next Block.
Illustrations vector created by freepik – www.freepik.com
Randomization is taken into account when it comes to forging, this is to eliminate the possibility of favoring a single node, or entity. Other factors that are also taken into consideration (of who’s going to win the contest) are how much funds are staked, as well as how long will they be staked for.
Okay, if we were to summarize Mining vs Staking in one simple sentence:
In Mining, users mine with their computers to gain rewards; and in Staking, users stake their coins to gain rewards.
Proof-of-Stake in Ethereum
Many newly-introduced coins out there are already embracing Proof-of-Stake. Amongst are coins like Cardano, Solana, Polkadot, Tezos, Harmony, and so on.
It is important to note that each coin has different rules when it comes to the calculation and distribution of rewards.
Ethereum 1.0 and Ethereum 2.0
Ethereum was purely based on Proof-of-Work only up until December 2020 when its blockchain, based on Proof-of-Stake, called “Beacon Chain” was created. The Proof-of-Work and Proof-of-Stake based Ethereum are referred to as Ethereum 1.0 and Ethereum 2.0 respectively.
And since Ethereum 2.0 is staked-based, you no longer mine to earn rewards. To earn rewards in Ethereum 2.0:
- You need to be a Validator.
- You need to lock up 32 ETH as stakes.
- You can only lock up (max) 32 ETH on a single node. To increase the chances of winning you will need multiple nodes.
At the time of this writing, Ethereum 2.0 runs alongside its original Ethereum 1.0 and will continue to do so until “the Docking” happens.
What is Docking?
Docking is the process whereby both Ethereum 1.0 and Ethereum 2.0 will be merged and Ethereum becomes a purely Proof-of-Stake network.
The Docking event (also known as The Merge) has been set to happen somewhere around June 2022 (but may be delayed). And only after the docking happens you will be able to cash out both your staked ETH and rewards.
Rewards for Staking Ethereum
Here’s to give you an idea of how much you can be potentially rewarded shall you choose to stake Ethereum.
In Ethereum 2.0, each participating validator gets a percentage of the newly minted ETH when it’s created.
So, if you stake 1 million ETH, the maximum annual reward could be as high as 18.1%. However, if 3 million ETH is staked, the reward can be reduced to 10.45%.
You can think of the annual reward as a fixed pie whereby the more Validators wanting the pie, the lesser each will get.
Check out this link if you want to know more about Ethereum 2.0 staking rewards.
Limitation of Staking Ethereum
All things considered (so far), staking Ethereum may sound tempting, but it does come with some limitations that may push one back.
Here to list a few:
- The process of signing up as a validator can be complicated.
- Setting up your own validator requires a vast amount of technical knowledge.
- You will also need a dedicated computer, and 32 ETH, which is not something everyone is willing to fork out for.
- If you mess up with the setting up process, or if it goes offline or is harmful to the network, you may be subjected to penalties or slashing where a portion of your stakes will be removed, or worse, you can be kicked out of the network.
- Only 900 new validators are accepted each day, the rest will have to wait in a queue. At the time this post is written, there are around 5000 validators pending and waiting to join. See the latest validator updates here.
Alternative ways for Ethereum Staking
Want to have skin in the game but are concerned with some of the limitations mentioned above? Well, fret not, there are some alternative ways to stake Ethereum and earn rewards without having to run your own nodes, or forking out 32 ETH.
Let’s take a look at some of the most common alternatives to staking Ethereum.
1. Staking Ethereum on Exchanges
This is the easiest way for any non-tech-savvy person to stake Ethereum. You can stake Ethereum via supported crypto exchanges out there. Some of the exchanges allow you to stake your coins through their validators (for a fee). This means even with a small amount, you can participate in staking Ethereum.
Some exchanges even allow you to claim your staking rewards immediately instead of waiting until the docking phase. While this removes the hassle of running our own validators and all other advantages mentioned above, staking with exchanges means you are forfeiting control over your coins, leaving them to the mercy of chance.
Here are some exchanges that provide Ethereum staking:
2. Staking Ethereum on Staking Pools
Another option is to join a staking pool. While mining pools in Proof-of-Work consist of people joining together for better computing power to gain an edge over winning a contest, joining the staking pool shares a similar concept.
Staking pools are groups of people coming together, each depositing their desired staking amount, to get better chances at forging the next block. To go with this approach, it is also important to do your due diligence on the particular pool.
The things you need to concern yourself about are: “Is the pool’s validators reliable?“, “What are the pool fees?“, “Does it have good customer support?”, “What is the pool size?“, and “Do I need to give up my private keys?” etc.
Here are some of the better Ethereum staking pools out there:
3. Staking Ethereum via Validator-as-a-service
Lastly, you can also stake Ethereum via a third-party validator, also known as Validator-as-a-service. These companies will allow you to run your own validator on their servers, without the need to worry about the technicalities of setting up and maintenance.
The advantage of this approach is that you maintain control over your coins, and it is relatively easy to get started staking. However, since you are running it as a personal validator, this means you are required to deposit the 32 ETH for the node. You will also need to pay an additional fee for using the service.
In summary, staking is a way of participating in the process of updating a ledger of a transaction by putting your funds at stake and earning rewards for your contribution.
I hope you find this article useful and get a good grasp of what Proof-of-Work and Proof-of-Stake are. If you have any questions or comments do mention them in the comment section below.