Ethereum’s price jumped over 40% in mid-July following an announcement from the second-largest blockchain.
If you didn’t realize it at the time, you might be wondering what type of announcement has such power to drive up the price of Ethereum. It all comes down to the difference between Proof of Stake and Proof of Work – two different ways to validate transactions on a blockchain network.
In the case of Ethereum, a long-planned network upgrade called “The Merge” will shift its protocol from a proof-of-work model to a proof-of-stake model. After previous delays, the July announcement set September 19 as the new date when the change will take place.
While the difference may not be obvious to casual investors, many experts argue that proof-of-stake is a better and more efficient way to operate a blockchain network. “Proof-of-work and proof-of-stake are mechanisms used on these networks to verify transactions,” says Adam Blumberg, CFP, co-founder and president of Interaxis, a company that educates financial advisors about crypto assets. “However, for financial systems, proof-of-stake works best.”
Here’s an overview of proof-of-stake versus proof-of-work and what it means for investors.
What is proof of work and how does it work?
Proof of work (PoW) has been part of the crypto market since its inception, having been incorporated into the bitcoin blockchain when it was launched in 2009. In practice, proof of work means that when transactions are added to a network of given blockchain, other computers on the network must validate and approve them before new blocks are created and entered into the blockchain.
Proof of work requires computers to solve cryptographic puzzles, putting in “work” to be rewarded with the ability to verify or validate transactions on the blockchain. It’s called cryptocurrency mining, and it’s similar to a competition. The idea is that through a long string of numbers and letters, called hashes, it is possible to ward off malicious attacks and verify that a transaction is valid. When someone puts data through a function on the network, which is the basis of transactions on the blockchain, they can only generate one hash.
So when transactions (like transfers of a bitcoin to another person) occur on the blockchain, the resulting hash is distributed across the network. Any modification of the hash by tampering would be noticed and rejected.
Proof of work allows the blockchain to remain “trustless”, which means that no third parties are needed to verify or manage transactions.
“Proof of work, especially how it’s used for the bitcoin network, is kind of the ultimate in developing an asset,” Blumberg says. “Someone had to put in the time and effort and sometimes it’s the conversion of literal energy into value. That’s what makes it so powerful as the foundation of bitcoin’s value.
What is proof of stake and how does it work?
On the other hand, Proof of Stake (PoS) relies on validators who own the coins associated with the blockchain. With proof of stake, a validator is chosen at random, in part based on how many coins they have locked away in the blockchain network, also known as staking. Coins act as collateral and when a participant, or node, is chosen to validate a transaction, they receive a reward.
Proof of Stake requires multiple validators to agree that a transaction is accurate, and once enough nodes have verified the transaction, it is accepted.
“Proof-of-stake is much more energy-efficient,” says Blumberg. “There is not enough energy in the world to power a decentralized financial ecosystem on the scale desired by Ethereum and other blockchains.”
Part of the challenge of Proof of Stake versus Proof of Work is maintaining the security and decentralization offered by PoW when using PoS. Blumberg points out that for decentralized finance (DeFi) to be viable in the long term, the PoS model must offer security and speed and enable real-time transactions.
Advantages and disadvantages of PoW
Proof of work is a more decentralized way to validate transactions on a blockchain because it requires more computers and network participants to review and approve transactions. For many crypto purists and enthusiasts, the more decentralized the better.
But on the other hand, more computers means more power consumption. The environmental impact of cryptocurrency mining has garnered more interest and scrutiny over the past year as more and more people have been drawn to the industry. The complexity and higher barrier to entry is largely by design and has the effect of preventing hacks and attacks, another plague of the crypto market.
Ultimately, proof of work means slower speeds and greater potential for negative environmental impact, which has limited its appeal in the crypto industry. “It’s just not practical for some of the blockchain use cases,” Blumberg says.
Slower transaction speeds
Higher costs to validate transactions
Higher energy consumption
Advantages and disadvantages of point of sale
Proof-of-stake offers key advantages over proof-of-work, experts say. Its faster transaction speeds and more efficient power requirements enable blockchains that are more scalable and therefore easier to adopt among new users.
On top of that, proof of stake offers opportunities to earn more crypto. You can lock your coins in a liquidity pool and receive rewards in the form of more coins. This offers more opportunities to earn money and integrate into a financial system on a proof-of-stake network than on a proof-of-work network.
Although the rewards can sometimes be lucrative, experts recommend being extra careful in the cryptocurrencies you invest in. Because the market is still in its infancy, many cryptos – especially smaller altcoins that could offer bigger staking rewards – have more potential to crash and fall.
Proof of Work vs. Proof of Stake Power Consumption
Power consumption is much higher with proof-of-work than with proof-of-stake. The bitcoin network alone, for example, consumes as much energy as an entire country like Malaysia or Sweden, according to data from the Cambridge Center for Alternative Finance.
This is partly because PoW requires more advanced equipment. Some bitcoin miners use large, elaborate computer systems to do the work.
Proof of stake requires much less energy and no specialized equipment. As a result, it is considered a greener alternative to proof of work. The Ethereum Foundation claims that its move to PoS will result in a network that uses almost 100% less energy.
Blockchains that use Proof of Stake or Proof of Work
The most prominent blockchain platform that uses PoW is Bitcoin. However, other blockchains like Bitcoin Cash, Dogecoin, Monero, and Litecoin also use proof of work.
Ethereum is also a PoW blockchain, but only for now. Ethereum has built a PoS blockchain it calls Beacon and will merge its current Mainnet chain with Beacon to transition to a proof-of-stake model.
Ultimately, Blumberg believes PoW and PoS will continue to be used, along with other alternatives like Solana that add a mechanism called proof of history to validate transactions.
“Proof of work has its place and Bitcoin will continue to be important,” says Blumberg. “But you can’t build a financial system on proof of work. For all this you need proof of stake and proof of history.
What does all of this mean for crypto investors?
For the casual crypto investor, the difference between proof of work and proof of stake is not as important as many other basic metrics and considerations. Things like trading history, market capitalization, and price provide more valuable insights for investors looking to make smart decisions on which cryptos to invest or trade.
Experts say the smartest way to invest in cryptocurrency is to keep it to less than 5% of your overall portfolio, and not invest if it gets in the way of building and maintaining a fund. strong emergency, or if it prevents you from paying off high interest debt such as a credit card or personal loan.