In today’s Exponential Investor:

  • Pros and cons of proof-of-stake
  • Pros and cons of proof-of-work
  • Which cryptos use proof-of-stake/work

The schtick of crypto is sticking it to “The Man” – there’s no central authority. Anti-establishment crypto types dig this, at least until someone does them wrong – they seem to have no problem appealing through the court systems when it helps them. But I digress.

Cryptos work using blockchains, which are like long, crowdsourced transaction records on Google Sheets (Google’s copy of Microsoft Excel, which allows for multiple users to either view or edit, depending on the owner’s settings).

The blockchain is the official, immutable-or-nearly-immutable-once-it’s-encoded record – a public ledger that anyone can view.

But not anyone can edit. That’s the point. Crypto replaces The Man with The Crowd, sort of. The basic ideas are:

  1. Anybody can see the blockchain, but only a small number of people or entities will be allowed to modify (validate) it.
  2. To get honest validators, it needs to be hard to be a validator.
  3. It also needs to be hard for a validator to be big enough to tip the whole system.
  4. There needs to be some reward for being a validator, or else people won’t do it.


So what is the difference between proof-of-stake and proof-of-work?

Proof-of-work

Validationinvolves making validators (miners in this case) solve a mathematics problem. With bitcoin, multiple miners compete to solve the same problem, with the winner earning the right to add some random guy’s transaction record (block) to the blockchain, and getting paid some bitcoin for doing so. With Ethereum, I don’t believe miners compete, but the process is otherwise similar. Proof-of-work has become its own not-so-cottage industry, which has driven up the prices of electricity and fast-processing semiconductor chips.

Bitcoin purely validates with proof of work, whereas Ethereum uses mostly energy-intensive proof of work and, more recently through a side project that’ll be merged into and in the validation aspect subsume the main Ethereum, a bit of proof-of-stake validation.

Pros

  • More time-proven at large scale (than proof of stake)
  • Less centralised
  • Arguably more secure (security is hotly debated).

Cons

  • Massively more energy usage
  • Because of massive energy usage, less scalable in a global sense.

Which cryptos use proof-of-work?

  • Bitcoin
  • Ethereum (pre-merge)
  • Dogecoin
  • Litecoin
  • Monero
  • Zcash
  • More examples here.

Proof-of-stake

Validation requires validators (stakers in this case) to ante up, or put down a security deposit, depending on how you’d like to see it. This is in case they do something bad. Proof-of-stake systems have algorithms that award staking rights (which are paid, remember?) more heavily to validators who have staked large deposits as well as have long staking histories.

Staking can be crowdsourced: on paper, a staker may appear to be a single entity, but it may embed hundreds or thousands of deposits from individual investors.

How much do stakers get for staking? It varies from mid-single digit yearly yields for Ethereum currently to almost 20% for sketchier projects essentially paying huge returns out of their own hide in attempts to get a critical mass of users and (more importantly) capital on to their platforms before they fail like the thousands of other cryptocurrencies. My belief is that this “failure” website massively undercounts, by the way.

The staking fee is not in cash. Heaven forbid. It’s “in kind” – similar to how a stock dividend differs from a more common cash dividend by actually issuing equity to recipients. Those 20% yields are not paid for out of the cosmos, in other words – they come out of the pockets of existing owners. This sounds bad, and it is very bad if the rate is unsustainably high. But remember that if you’re trying to establish a new currency, the only yield you can practically offer is your own currency.

Pros

  • Exponentially less energy used (relative to proof of work)
  • Quicker transaction times
  • Stakers don’t have to do as much as miners, opening participation to passive investors.

Cons

  • Risks becoming more centralised as big stakers gain more clout
  • Less secure
  • The anteing (I knew I’d use this word once in my life) process looks very much like an investment to sovereign regulators, who may potentially regulate proof-of-stake coins under more restrictive terms. Note that this “con” is highly country-specific.

Which cryptos use proof-of-stake

  • Ethereum (post-merge)
  • Cardano
  • Solano
  • Algorand
  • Tezos
  • Mina
  • More examples provided by CoinMarketCap.

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James Early
Editor, Southbank Investment Research