THIS WEEK the price of bitcoin briefly dropped below $30,000, more than 50% off its April peak of almost $65,000. Investors are worried by a growing regulatory crackdown against the cryptocurrency. On June 21st China ordered several state-owned banks and Alipay, a fintech giant, to track and block transactions linked to it. Among other things, regulators worry about the environmental damage caused by the mechanism bitcoin uses to verify transactions and put new coins into circulation, known as “proof of work” (POW). In periods of high activity, as witnessed during much of 2021, bitcoin burns more energy than the whole of Argentina. The glaring inefficiencies of that process also explain why payments in bitcoin are slow and costly, and thus a rarity. That has fed appetite for alternative mechanisms, the most popular of which is dubbed “proof of stake” (POS). Ether, the second-most popular cryptocurrency after bitcoin, is preparing to switch to it; smaller coins already use it. What is POS, and can it solve bitcoin’s problems?
POW’s raison d’être lies in that of bitcoin itself. As a decentralised currency, bitcoin lacks a trusted central authority that validates transactions. Instead it relies on a public consensus mechanism where each block of transactions is validated by someone on the network and then verified by everyone else. Miners put blocks together by picking pending transactions from a pool, ascertaining they are legitimate by checking, for example, that bitcoins are being spent by their true owner. To earn the right to add their block to the blockchain—the database that records transactions—miners compete to be the first to solve a complex numerical problem using super-fast computers. The one who does gets rewarded in new bitcoins. This sucks up huge amounts of energy, making POW both an ecological disaster and a crummy verification method (bitcoin can only process around seven transactions per second).
POS is an alternative consensus mechanism which doles out rewards based not on who first solves a mathematical puzzle but how much has been “staked” by competing validators. To earn the chance to validate transactions, network users must place coins in a specific digital wallet, where that sum—the stake—will remain frozen until the block of transactions is processed. Instead of paying out to those with the most computing power, POS picks winners randomly, with the probability of being chosen linked to the amount staked. Unlike POW, which pays miners with both a reward every time they create a new block and a fee per transaction, POS only does the latter. All this means the process requires far less equipment and energy than POW. Validators are incentivised to keep the network secure: the more they stake, the more they earn, but the more they also stand to lose if they try to hack the network or validate fraudulent transactions.
But POS has downsides too. It is less effective at putting new currency into circulation. It also encourages hoarding, since the probability of earning big fees rises in tandem with how much is held in escrow wallets, rather than spent in transactions. That is bad for a currency’s availability and liquidity, which limits its usefulness and makes its value even more volatile. It could also end up concentrating validating powers in fewer and fewer hands, defeating the purpose of decentralisation. In POW, by contrast, miners are encouraged not to cling on to their crypto, since to engage in the mining arms race they constantly need fresh real-world funds to upgrade their hardware. This unsatisfactory state of affairs has led to a mushrooming of hybrid protocols, such as “proof of activity” or “proof of burn”. Others, such as “proof of capacity”, which rewards users based on how much space they have on their hard drives, use different methods. But none of them has yet managed to steal POW’s crown, and with it knock bitcoin off the top spot.