Bitcove Blog

News and updates from the Ireland's leading cryptocurrency exchange

01-04-2021

What is a blockchain?

A blockchain is a decentralised, trusted database shared across a network of computers. Any information added to this network is extremely difficult to change. To date, blockchain technology has mainly been used as a transaction ledger for cryptocurrencies. However, there are a multitude of new, emerging uses for the technology.

Blockchain networks make constant checks to ensure all copies of the database are identical. Each member (computer) on the network is called a node. All blockchain networks require all transactions that occur on the network to be validated (checked to prove information is accurate). Each node plays a role in validating the network data.

There are a number of different validation methods used to secure blockchain networks, Proof of Stake mechanisms have been on the rise in recent times. Seen as a more energy efficient alternative to the previously used Proof of Work methods, PoS validation systems have a lot of future potential uses.

Proof of Stake

Proof of Stake Validation:

What is it and how does it work?

Proof of Stake is a form of consensus mechanism where network users pool funds together (stake) as a form of collateral to ensure participating members contribute to the security and operations of the blockchain. Contributing members are rewarded for their participation in the process. While funds are staked, the user who owns the coins cannot access them but maintains ownership throughout the process. The rewards received are usually in the form of a percentage of the locked coin or as other cryptocurrencies.

Proof of Stake validation has the same goal as Proof of Work validation (check out our article on PoW here) to verify transactions on the next block in the blockchain - in simple terms, checking all new data being added to the network is relevant, correct and non fraudulent. In a Proof of Stake System, a single node is selected as a validator. After this node is selected it checks whether the transactions in the block are valid, signs the block and adds it to the blockchain. This node receives the transaction fees associated with the newly validated block as a reward for assisting in network validation.

Proof of Stake 2

Choosing a Validator:

Validator nodes are selected by the network in a deterministic manner based on a number of factors. Each network has different rules on how it calculates and distributes rewards. Selection factors for node verification often include (but are not limited to the following):

  1. How many coins the validator is staking
  2. How long the validator has been actively staking
  3. Total number of coins being staked on the network
  4. Randomization - to prevent any one individual/group having unfair control over the network

PoS based systems consume much less energy as only one node is required to check each new set of transactions. Member nodes can skew the odds of being picked as said validator in their favour based on the above criteria, however, ‘every day’ users still have a chance of profiting from block validation due to mining pools (discussed below) and the element of randomization. This is unlike Proof of Work systems where a ‘rich-get-richer’ scenario tends to unfold as block validation comes down to who has the most processing power available.

Some PoS systems often include conditions to avoid the same node being selected as a validator too often. For example, Coin Age is a common metric to select new validator nodes. Once a node is selected based on this criteria, their Coin Age metric is reduced back to 0. This ensures large stake nodes do not dominate the blockchain which bolsters the security of PoS networks and maintains decentralization.

In PoS systems a reward for block validation is paid as a transaction fee (not by newly issued coins as is the case with PoW systems). The process of adding new blocks to a Proof of Stake system is called “minting” or “forging”.

Decentralization:

Unlike banks, where there is one central entity in control of the overall ledger/transactions. PoS networks are decentralized with the entire network controlling and validating the transactions that occur on it. This gives more security to the network by ensuring a singular governing body does not make executive decisions related to the running of the network. As mentioned, PoS systems are consensus mechanisms.

Proof of Stake 3

Consensus mechanisms operate by requiring 51% of the network participants to agree that a set of transactions are valid before they are added to the blockchain. If an individual or group wanted to harm the blockchain (i.e. alter data/input false information) they would need to control 51% of the overall stake on the network. This level of wealth would be near impossible to amass and makes such attacks extremely difficult and unlikely.

Furthermore, even if such an attack did occur, the attackers’ staked funds would remain locked in the network for a period of time after the compromised block was added. Some networks employ a tactic known as “slashing” which is the destruction or redistribution of staked capital if the owner is found to breach the terms of the network.

At the most basic level, Proof of Stake networks reward good behaviour and punish bad behaviour on the network.

Barriers to Entry:

Certain PoS networks have minimum staking requirements. Ethereum 2.0 (not yet fully developed) for example, has a minimum stake of 32 ETH which is a substantial investment. Furthermore, some PoS networks (such as the aforementioned Eth 2.0) have minimum staking duration limits. This means that once a user hands over their coins, there is a set time limit before they can access them again. These limits vary from network to network but can extend into months, if not years. Time limits such as this can help reduce price volatility of a given token as large sums of the currency remain ‘locked in’ within the network at any given time. However, stipulations such as these can make getting involved in staking difficult for the average person.

Mining Pools developed as a solution to the two hurdles mentioned above. Many members can pool their resources together to reach minimum requirements and split the rewards proportionally among the group. Some exchanges allow users to contribute towards mining pools, other pools are private. It is important to do thorough research before submitting funds to a private pool to ensure its trustworthiness. Mining pools offered by exchanges tend not to have time restrictions on fund allocated, meaning users can access their staked funds (along with potential profits) whenever they like. It is extremely important to understand the conditions of a certain pool before attributing funds towards it.

Is staking safe?

Assuming the exchange or mining pool being used is trustworthy - staking is completely safe. The coins staked remain yours while they are ‘locked’ within a PoS system. The coins/currency are still subject to the ups and downs of the market and cannot be traded while staked. Using Cardano (ADA) as an example, by staking your coins you actively support the Cardano network by allocating resources to it and contribute to the stability of the network. In return for your support, you earn ADA tokens as a reward.

The returns vary widely from coin to coin - a typical Annual Percentage Yield (APY) associated with ADA is around 7%. Some lesser known altcoins offer upwards of 80% APY as an incentive to attract new users to the platforms. Profit margins also vary from anywhere in between these numbers.

These new avenues to blockchain validation open up many more opportunities for anyone wishing to participate in the consensus and governance of blockchain networks. What’s more, it’s an utterly easy way to earn passive income by simply holding coins - it is a fantastic method to increase profits, especially for those who have plans to hold a particular coin long term. Proof of Stake networks offer a new form of blockchain validation that is a lot more energy efficient than Proof of Work networks. PoS networks also allow for easier profitability for everyday users without the need to invest in expensive technology (mining equipment) and can be done with low levels of funds through mining pools. Cardano is one of the most popular coins currently staked and can be purchased right here at Bitcove.

Summary:

We now know that certain cryptocurrencies (e.g. Cardano - ADA) can be locked within its network as Proof of Stake for members to actively secure and contribute to the network. This stake prevents members from acting maliciously against other members or the network itself as they might lose their stake as punishment for these sorts of unwanted actions. In return, staking members gain coin rewards for adding to the network security.

As always, we’re very keen to hear from our users: What do you think of staking? Will you get involved? Do you think Proof of Stake consensus mechanisms will eclipse Proof of Work models?