The cryptocurrency industry is talking a lot about proof of stake, and for good reason. Ethereum (ETH 0.07%), the second-largest crypto by market cap, is moving to a proof-of-stake consensus mechanism -- an alternative to Bitcoin's (BTC -0.45%) proof-of-work blockchain management method. Some crypto investors are optimistic that Ethereum's "merge" to proof of stake will help increase the adoption of blockchain technology.
But what exactly is proof of stake in cryptocurrency? Here's what you need to know.
How proof of stake works in crypto
As a quick refresher, blockchain is a digital ledger of past transactions that have taken place on a network. This digital ledger (a piece of software) is distributed to validator nodes -- computers used to verify transactions taking place on the blockchain network.
Proof of stake is a method for a blockchain network to verify these new transactions before adding them as a new block of data to the chain of historical records. To participate as a validator, a computer node can "stake" the native tokens of a blockchain network (ether, for example, is the token for the Ethereum network).
When a transaction request is made, the network randomly chooses a validator to verify the transaction. Typically, the more crypto a validator is staking, the higher the chance it will be selected to validate the transaction and earn a staking reward for the computing effort.
By contrast, proof of work is when powerful computers known as "miners" compete to solve mathematical problems called hashing algorithms. The first miner to solve the hashing algorithm validates the new block of data and earns a reward. All computing work (blockchain networks included) requires energy to operate.
Since proof of work involves solving increasingly complex mathematical problems, but only one miner ultimately wins, proof of work has become an increasingly energy-intensive operation.
This is why cryptos that use proof of work like Bitcoin (and Ethereum, at least up until "the Merge" to proof of stake is complete) have come under fire for their high use of energy. Since the selection of block validation is randomized in proof of stake, though, it is far more energy-efficient than proof of work.
In simple terms, if the original blockchain mechanism proof of work is a computing power competition, proof of stake is a lottery system.
Proof of stake: Further democratization and decentralization of computing?
We've already discussed one big benefit of proof of stake: energy efficiency. Given the high cost involved in operating blockchain networks like Bitcoin, proof of stake holds a lot of appeal to many in the crypto community. But there are other potential benefits, too.
One is that proof of stake is faster at validating new blocks of information, which speeds up the time to compute transaction requests on a blockchain network. As crypto gains in popularity as a means of executing contracts or making digital payments, transaction speed becomes an important factor for developers when selecting a blockchain network to build their dApp (decentralized application) on.
Another benefit of proof of stake is that it requires no special computing equipment to participate in the management of a blockchain network. Someone operating a validator node will likely need to dedicate a computer to the task, but investors can pool their staked tokens together to create a staking pool. A large pool of staked tokens will have a greater chance of being selected to validate transactions and earn crypto rewards. To participate, investors simply need to designate their eligible crypto tokens as "staked" with the crypto exchange or crypto wallet being used to hold their digital assets.
Proof of stake thus has the potential to further democratize digital payments and decentralized computing networks by giving investors a way to monetize their day-to-day operations. It isn't a perfect solution, though. Investors and validators with the financial resources to amass a large number of tokens have a higher chance of earning a staking reward. And, of course, there's the inherent volatility involved with crypto prices. Earning a staking reward only goes so far if a crypto's value crashes.
Nevertheless, the benefits of proof of stake are being fleshed out, and Ethereum's merge to the operating model is being watched closely in this nascent industry. Investors should take a measured approach to investing in this concept and remember to keep an investment in crypto (if any) as part of a well-diversified portfolio.