Proof-of-Stake Could Lead to Crypto Banking

A new hard fork Constantinople is about to happen in the Ethereum chain. It is a result of a greater battle within the crypto community about consensus algorithm. Unlike traditional file systems, in a blockchain, the data is distributed among many computers, this means that there is no single point of attack. But there is a catch. When trying to update a distributed system, consistency becomes a problem. This is called the Byzantine problem. This is where the consensus algorithm comes into play. Any update in the network is agreed upon by everyone in the network, thus maintaining consistency. The current battle happening within the crypto community is over which consensus algorithm is better.

Proof of work

Proof of work is the first and currently most popular consensus algorithm for blockchain applications. In this algorithm, every node tries to solve complex mathematical problems and in return, the node which solves the problem receives cryptocurrencies. The major part of the problem is verifying the transaction. Another property is the asymmetric nature of the problem. It is hard for the nodes to solve but easy enough for the network to verify. Proof of work is a brute force algorithm and the node with the most computing power has the chance of getting more reward. This system incentivizes the miner to add more computing power, but the hardness of the problem increases with the computing power of the network, so miners have to keep adding more computing power to increase rewards. This system ensures network consistency and security.

Proof of stake

Here, unlike in proof of work, a node is selected to verify the transaction from a preset list of trusted nodes, each node has to stake a certain amount of cryptocurrency in order to be eligible to get into the list. So what stops the selected trusted node from doing malicious activities? If a node is found out to be cheating the money at stake is taken as fine hence there is an economic incentive not to cheat. The procedure to verify the transaction is similar to the proof of work, but there is no competition among nodes to solve the problem. This lack of competition reduces the power consumption greatly.

Proof of work vs proof of stake

Proof of work ensures consistency, and the complexity ensures better security, also since anybody can participate it ensures decentralization. But energy consumption is a big concern when it comes to proof of work. Another concern is scalability. Proof of work is hard to scale to the level required for mainstream adoption of cryptocurrencies. This is the reason for delayed transactions as their number increases. In proof of work, there is no mechanism to punish bad actors. Proof of stake solves all the problems of proof of work but has a set of challenges of its own, it creates a barrier for entry as a huge amount of cryptocurrency is required to be kept as stake. The security is also a concern as some argue that it is easier to attack a POS than POW network.

Staking as a service

Most people do not have their own nodes running in their homes but rather, they buy cryptocurrencies and store them in a wallet. The cryptocurrency is actually kept with a third party. This third party could, in turn, use this cryptocurrency as a stake to take part in proof of stake, and in return, the customer receives an interest. Now we have returned to traditional banking. As proof of their assets that are kept by the third party, a certificate can be issued. At first, the certificate will be issued at 1:1 ratio, i.e. if one Bitcoin is taken for proof of stake the entity who takes the Bitcoin for staking issues a certificate. Over time, this certificate will be as good as the original thing. People start to trust the certificate as ownership of money. And now comes fractional banking since all the certificate holders would not come to withdraw their cryptocurrencies at once. It will not be a bad idea to issue 1.1 certificate for 1 coin deposited and the .1 can be loaned to an entrepreneur and over time 1.1 becomes 1.2, 1.3 … and now we are finally back to the banking system cryptocurrencies were meant to eliminate. Proof of stake is not perfect, just like anything else. Unless implemented properly, it can damage the core philosophy of cryptocurrencies.

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Posted By

Abishek Dharshan

Abishek is an Entrepreneur, Digital Nomad, Student, and ICO Marketing Manager currently based in Berlin & Champaign. He is actively involved in the Blockchain space and has worked in numerous projects in the Silicon Valley since 2017. His interests revolve around Finance, Consulting, and Blockchain Research.