Proof-of-Stake Ecosystem 101
Proof-of-Stake (PoS) is still a foreign concept to many, even within the blockchain space. Yet we see most next generation protocols adopting PoS approaches and a large ecosystem will form around the alternative to Proof-of-Work (PoW). Similar to how PoW gave rise to a multi-billion dollar industry centered around mining (ASIC producers, mining farms and pools, etc.) there is an opportunity for new types of network maintainers emerging.
To reason about how this market may evolve, we need to take a step back to understand Proof-of-Stake, its main actors, their incentives, as well as differences in PoS implementations. This post is the first of an ongoing series that will try to do just that by providing an analysis of the PoS ecosystem and how we at Chorus One have been thinking about this space while building out own staking operations over the past few months.
101: How does Proof-of-Stake work?
The first part of this series will provide a basic introduction to PoS and the concepts of validation and delegation. As some readers might know, I have already written about the different types of staking. The “Proof-of-Stake Ecosystem” series will focus on pure PoS implementations, meaning those in which the consensus process is directly influenced by the stake. But what does that mean in practice?
If we look at PoS from a high level the concept is quite clear; the term refers to a system where value at stake is the main determinant of which blocks are added to the blockchain. Participants in a Proof-of-Stake network essentially vote with their money on blocks of transactions that they deem valid, get rewarded if the majority of the network agrees and risk losing their stake (deposited tokens) if they try to cheat, e.g. by voting on two different blocks of transactions at the same time.
In PoS money is power; instead of requiring participants securing the network to spend electricity (PoW), PoS requires participants to acquire and utilize the network tokens themselves as security deposits to align them with the networks’ interests.
Staking in a PoS blockchain refers to depositing tokens in a smart contract to register the intent to take part in maintaining the blockchain ledger. Once these tokens (the stake) are registered in the network, the staking party is required to run node infrastructure that will participate in the consensus process by receiving, signing and sending messages (about blocks of transactions) to other peers in the network. The combination of stake and node infrastructure is commonly called a validator. The amount of stake registered in this way determines the influence in the consensus process and the rewards a validator receives for the work it performed. The graphic below illustrates this process that is often referred to as validation.
If the story ended here, to participate in Proof-of-Stake one would need to a) own the staking tokens and b) be able to run the infrastructure required to take part in validating the blockchain.
But then what would happen with token holders that want to stake their tokens to receive rewards but cannot, or do not want to operate the required validation infrastructure themselves? It turns out that the developers of most PoS protocols have thought about this case and figured out ways to enable token holders to stake their tokens with a validator that they do not run themselves, without requiring them to actually send the tokens to the validator, using a process that is commonly called delegation.
Delegating your tokens means letting them count towards the stake of a validator in return for a share of the reward received. In practice, a delegator deposits tokens in a smart contract specifying the validator whose influence in the network he wants to increase. As a result, the rewards earned in the validation process increase, but instead of only the validator receiving compensation, the rewards are automatically split between the validator and the delegator depending on how the delegation smart contract specifies it, usually by applying a simple commission rate as pictured below.
It’s important to note that this process is a) non-custodial, i.e. a validator can never access token holders staked cryptoassets, b) capable of being reproduced on any smart contract platform, and c) expandable in many ways, the example above only illustrating the idea behind the concept of delegation.
Point b) and c) become especially apparent when one looks at how PoS and delegation mechanisms are currently designed in protocols such as Tezos, Cosmos, Ethereum (developed by third parties, e.g. Rocket Pool), Cardano, etc. There are massive differences in how delegation is implemented in these protocols, especially with regards to payout distribution and the treatment of parties that delegated their tokens to malicious validators, I will touch on some of these differences in the final part of this series.
The next post of this series will be about incentives and disincentives in the Proof-of-Stake ecosystem. It will try to lay out which factors drive the decision to delegate tokens instead of operating validator nodes yourself, or even starting your own delegation operation. To be the first to hear about new posts, sign up for our email list, follow the Chorus One Twitter account, or join our other social channels.