Anyone who has invested in cryptocurrency will have probably heard the terms ‘Proof Stake’ (PoS) and ‘Proof of Work’ (PoW). But what do they mean?
Cryptocurrencies are decentralized, meaning there is no single authority to validate transactions. As such, consensus mechanisms are required to ensure transactions are processed and completed accurately. The two most popular consensus mechanisms are PoW and PoS. Each serves the same purpose but works in a very different way.
Why Do Investors Need to Know the Difference?
It’s always best for investors to understand how investments work. Cryptocurrencies are hugely complex, and it’s impractical for most traders to fully understand how they operate. But having a basic understanding is essential. Those considering a ‘real world’ investment will look at background data and check the economic calendar this week to assess how it might perform.
Digital investment requires a similar approach. Whether a cryptocurrency uses PoS or PoW will affect what type of investments it can be used for, how secure it is, and how quickly transactions are likely to be processed.
What Is Proof of Work?
PoW was the first consensus mechanism. It was introduced by Bitcoin in 2009 and relies on ‘miners’ to validate transactions.
All transactions on a chain are placed into digital blocks, which must then be validated to transfer the data or coins. This is done by solving complex cryptographic equations. Miners use ASICs (application-specific integrated circuits) to compete to be the first to solve the problem, with the winner validating the block and adding it to the chain (hence the term blockchain) in exchange for a predetermined amount of its native currency.
It’s generally considered the most secure consensus mechanism but requires huge expense to buy ASICs and uses vast amounts of energy. As a cryptocurrency becomes more successful and the equations more complex, PoW protocols can face network congestion that slows the process, making it difficult for platforms to scale.
What Is Proof of Stake?
PoS was created in response to the high cost, scalability issues, and environmental impact of PoW.
Rather than miners competing to solve equations, PoS uses ‘validators’ who lock in an amount of crypto as a ‘stake’ to earn the right to validate blocks. While the validator for each block is chosen somewhat randomly, the higher your stake, the more chance you have of being selected.
Once again, when a block has been verified, it is added to the chain, and the validator is rewarded.
Critics say PoS goes against the decentralized nature of cryptocurrencies as there are no real limits to how much one user can stake.
PoS is typically used for more modern blockchains that require multiple transaction types, such as NFTs (non-fungible tokens) and smart contracts.
While its security is yet to be fully tested against malicious actors, an attack on PoS would be so expensive it is almost entirely impractical. If an investor tried to buy up a sufficient number of coins to gain overall control of the network, they would push up the price to such a degree that any benefit of trying to defraud the protocol would be lost.
Which Is Better?
Neither is objectively better than the other. But it’s important to consider the consensus mechanism along with other criteria before investing in cryptocurrency. Each method had pros and cons, and there are traders willing to put forward an argument for each as the primary option.
The trick, as with any investment, is to read up on the different opinions and decide which suits your investment strategy best.
