Ethereum’s price surged by more than 40% in mid-July following an announcement by the second-largest blockchain.
If you didn’t catch it at the time, you might wonder what kind of announcement has such power to send the price of ethereum surging. 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 ethereum’s case, a long-planned network upgrade referred to as “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 Sept. 19 as the new date for the switch to take place.
While the difference isn’t likely to be obvious to casual investors, many experts say proof of stake is a better, more efficient way to operate a blockchain network. “Both proof of work and proof of stake are mechanisms used across these networks to verify transactions,” says Adam Blumberg, CFP, co-founder and president of Interaxis, a firm that educates financial advisors about crypto assets. “However, for financial systems, proof of stake works better.”
Here’s a look at 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 a part of the crypto market since its earliest days, having been built into the bitcoin blockchain when it launched in 2009. In practice, proof of work means that as transactions are added to a given blockchain network, other computers within the network must validate and approve of 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 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’s possible to stave 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, it can only generate one hash.
So, when transactions (like transfers of a bitcoin to another person) happen on the blockchain, the resulting hash is distributed across the entire network. Any change to the hash by tampering would be noticed and rejected.
Proof of work provides a way for the blockchain to remain “trustless,” meaning no third-party is necessary to verify or manage the transactions.
“Proof of work, especially the way it’s used for the bitcoin network, is kind of the ultimate in developing an asset,” Blumberg says. “Someone had to put in time and effort and sometimes its the conversion of literal energy to value. That’s what makes it so powerful as an underpinning 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 randomly, based in part on how many coins they have locked up in the blockchain network, also known as staking. The 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 verify the transaction, it goes through.
“Proof of stake is much more energy efficient,” Blumberg says. “There’s not enough energy in the whole world to power a decentralized finance ecosystem on the scale that ethereum and other blockchains want.”
Part of the challenge of proof of stake vs proof of work is maintaining the security and decentralization offered by PoW when using PoS. Blumberg points out that in order for decentralized finance (DeFi) to be viable long-term, the PoS model needs to offer security and speed and allow for real-time transactions.
Pros and Cons of PoW
Proof of work is a more decentralized way of validating transactions on a blockchain because it requires more computers and participants across the network to review and approve of transactions. To many crypto purists and enthusiasts, the more decentralized the better.
But on the other hand, more computers means more energy use. The environmental impact of cryptocurrency mining has drawn more interest and scrutiny over the past year or so as 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 bane of the crypto market.
At the end of the day, proof of work means slower speeds and more potential for negative environmental impact, which has limited its appeal in the crypto industry. “It’s just not practical for some of the use cases for the blockchain,” Blumberg says.
Slower transaction speeds
Higher costs to validate transactions
Higher energy consumption
Pros and Cons of PoS
Proof of stake offers key advantages compared to proof of work, experts say. Its faster transaction speeds and more efficient energy requirements allow for blockchains that are more scalable and thus easier to find more adoption among new users.
On top of that, proof of stake provides opportunities to earn more crypto. You can lock up 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.
Though the rewards can sometimes be lucrative, experts recommend taking extra caution in what cryptocurrencies you invest in. Because the market is still in its infancy, many cryptos — especially smaller altcoins that might offer bigger staking rewards — have more potential to collapse and fall.
Proof of Work vs. Proof of Stake Energy Consumption
Energy consumption is much higher with proof of work than with proof of stake. The bitcoin network alone, for example, uses as much power as an entire country like Malaysia or Sweden, according to data from the Cambridge Center for Alternative Finance.
Part of that has to do with the fact that PoW requires more advanced equipment. Some bitcoin miners use large, elaborate computing systems to do the work.
Proof of stake requires much less energy and no specialized equipment. As a result, it is considered a more environmentally-friendly alternative to proof of work. The Ethereum Foundation says its switch to PoS will result in a network that uses nearly 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 the time being. Ethereum has built a PoS blockchain it calls Beacon and will be merging its current Mainnet chain with Beacon to shift to a proof of stake model.
In the end, Blumberg thinks that both 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 keep being important,” Blumberg says. “But you can’t build a financial system on proof of work. For all of that, you need proof of stake and proof of history.”
What Does It All Mean for Crypto Investors?
For the casual crypto investor, the difference between proof of work and proof of stake isn’t as important as many other core metrics and considerations. Things like trading history, market capitalization, and price provide more valuable information to investors looking to make smart decisions about what cryptos to invest in or to take a pass on.
Experts say the smartest way to invest in cryptocurrency is to keep it to less than 5% of your overall portfolio, and not to invest if it will get in the way of building and maintaining a solid emergency fund, or if it will prevent you from paying down high-interest debt like credit card or personal loan debt.