What is Staking and how does it work?

Staking can be understood as a kind of analogue of mining. According to Coinmarketrate.com it is based on a Proof-of-Stake consensus mechanism in which existing blocks from the blockchain are used to certify new blocks. Users have the opportunity to receive rewards by owning certain cryptocurrencies.

But, in order to understand the principle of staking, it is necessary to consider the difference between blockchain consensus – Proof-of-Work and Proof-of-Stake.

How the Proof-of-Work (PoW) Consensus Works

Proof-of-Work (PoW) is a consensus algorithm used in Bitcoin, and also known as mining. In this mechanism, each miner can check whether the blockchain complies with the rules. To do this, you need to perform arithmetic operations to find results with certain properties.

The result should be obtained using an algorithm known to all miners. To find this result, miners perform billions of calculations per second, going through all possible input values until a result corresponding to the specified output value is found.

How the Proof-of-Stake (PoS) Consensus process Works

Proof-of-Stake (PoS) is also an appropriate consensus procedure for reaching consensus on the blockchain network about which user can generate the next block. However, not all users can equally participate in this procedure: instead, a weighted random selection is made. It depends on how high the assets (“count”) of the respective participants are.

Unlike the PoW mechanism used in Bitcoin, PoS does not require labor- and energy-intensive mining.

Staking refers to the PoS mechanism. Here, the owners of cryptocurrencies use their coins to add new blocks to the blockchain and receive rewards in return.

PoW vs PoS: Differences

Thus, PoW and PoS work according to different rules. Both concepts have their advantages and disadvantages. Which mechanism is better is a controversial issue in practice. Three criteria are crucial in the PoS vs discussion. PoW: Power consumption, scalability and security.

PoS has advantages in terms of power consumption and scalability. However, PoS is decentralized only to a limited extent, since rising prices sooner or later leads to an increasing concentration of assets. Small investors are excluded from the verification process because the weighted randomness algorithm “does not notice” them.

How does cryptocurrency staking work?

In the blockchain, all transactions are recorded in separate blocks. Together, the blocks form a chain. This chain is constantly growing because new transactions are constantly being added. All transactions must be confirmed. This is where PoS comes to the rescue.

PoS uses existing blocks from the blockchain to confirm new blocks.

• Weighted random algorithm in the proof of the share

The mining provided for by the PoW concept is no longer needed when using PoS. This provides significant advantages in terms of energy consumption, which is sharply criticized, for example, in the study of Stoll et al. under the name “Bitcoin’s Carbon Footprint”.

In practice, this means that anyone who holds certain cryptocurrencies in their wallet can confirm transactions. Which of the users or blocks is “responsible” for the next validation is decided by the principle of weighted randomness. A user who owns a large number of coins has a higher probability that he will be assigned the next transaction confirmation process.

This means that the share of cryptocurrency determines the validation process.

Coins must be stored and made available to the blockchain. On the crypto exchange, this is done through the “staking pool”, which regularly pays rewards.

• The difference between mining and staking pools

Staking pools should not be confused with mining pools. In mining pools, users combine their computing power for more efficient mining. In staking pools, capital is pooled instead to increase the probability of distribution of the next validation process.

Cryptocurrencies and Staking

Staking is available only to cryptocurrencies of the PoS consensus mechanism.

With Bitcoin, the situation is different. However, some other cryptocurrencies provide PoS. A striking example can be such cryptocurrencies as Decimal Chain (DEL), Cardano (ADA), Solana (SOL), Polkadot (DOT) and many others.

Ethereum 2.0 is especially worth mentioning here. Although Ethereum still relies on PoW, Ethereum 2.0 is designed to trigger the transition from PoW to PoS.

Ethereum 2.0 as a Catalyst

Ethereum 2.0 is an update of Ethereum, the purpose of which is to move from the Proof-of-Work consensus mechanism to Proof-of-Stake.

The restructuring process was started at the end of 2020. At this stage, a new PoS blockchain was created. This so-called “Beacon Chain” works in parallel with the Ethereum blockchain. Beacon Chain uses a Proof-of-Stake consensus mechanism. Anyone who deposited at least 32 ETH and exchanged them for the new ETH2 cryptocurrency has since been able to participate in the confirmation process of the new blockchain.

What are the risks associated with staking?

Anyone who wants to engage in staking usually faces a lockdown or a hold period during the process. During this period, the coins cannot be used elsewhere. This may be unprofitable with strong upward or downward price movements.

The long-term development of a large cryptocurrency based on PoS will also be interesting. Finally, there is little empirical data on the long-term horizon of development and concentration of assets.

Indeed, from this point of view, it is necessary to take into account the effect of a compound percentage of staking. Thanks to him, early adopters and investors with large capital receive more and more coins and, thus, can confirm more and more blocks. This leads to a concentration of power and capital.

Financially strong investors, in particular, benefit greatly from the effect of compound interest, while small investors increasingly find themselves on the sidelines.

Conclusion

Staking refers to the option of validating new cryptocurrency blocks. Unlike mining, active mining is not required, since validation takes place by referring to already existing cryptocurrency units.

Since PoS serves as the basis for mining, staking can be considered as a reasonable alternative to mining amid discussions about energy consumption and climate change. There is a reward for confirming new blocks, some of which promise high profits.

Whether PoS and staking are better or worse than PoW and mining is a moot point.