Proof of work versus proof of stake

In short

A friend of mine once asked how a computer network can agree on who owns what without a bank in the middle. Proof of work and proof of stake are two different answers to that one question. Proof of work makes people spend electricity to earn the right to add records. Proof of stake makes people lock up coins they already own, and they lose some of those coins if they cheat. You will do well to learn which system a coin uses, because it shapes the costs you pay and the risks you face. Neither one is free of trade offs, and neither one is a promise of anything. Read on, and by the end you will be able to explain the difference to a neighbor over the fence.

The whole of it

What it is

I once watched my uncle count ballots at a county fair, and what struck me was how much everyone trusted him. He was honest, and everyone knew it. A crypto network has no uncle like that. It has thousands of strangers who must agree on one shared list of who sent what to whom.

That shared list is called a blockchain. It is a record book that grows by adding pages, which people call blocks. The hard part is deciding who gets to add the next page, because a dishonest person could try to slip in a false one. Proof of work and proof of stake are the two main rules for settling that.

Think of it as a contest. Under proof of work, the prize goes to whoever does the most costly work. Under proof of stake, the prize goes to someone chosen in part by how much they have put at risk. Different contests, same goal. Keep the record honest.

How it works

If you have ever seen a long line at a hardware store, you know that waiting costs something. Proof of work uses that idea. Computers called miners race to solve a hard math puzzle. There is no clever shortcut, so the only way to win is to guess very fast, again and again. That guessing burns electricity and wears out equipment.

The winner of the race gets to add the next page and collects a reward in the network's coin, plus any fees users paid. Here is the clever part. To rewrite old pages, a cheater would have to redo all that work and outrun everyone else. That would cost a fortune. The cost of the work is what keeps the record safe. Bitcoin works this way.

Proof of stake takes a different road. A friend of mine runs a small hardware store, and he told me he trusts customers who have money on account with him. They have something to lose. Proof of stake thinks the same way. People called validators lock up some of their own coins as a deposit, and this deposit is called a stake.

The network then picks validators to propose and approve new pages. A bigger stake usually means more chances to be picked. If a validator signs off on a false page, or goes offline at the wrong time, the network can destroy part of the deposit. That penalty is called slashing. Ethereum moved to this method in September 2022, and the Ethereum Foundation explains the change on its website, ethereum.org.

So the safety comes from different places. In one system, it comes from the cost of electricity and machines. In the other, it comes from the cost of losing your own coins. Both aim to make cheating cost more than it could ever pay.

The numbers, and where to find yours

You have probably wondered what these systems cost the people who use them. For a plain user who sends coins, the main cost is the network fee, and it changes from minute to minute. Your wallet app shows the fee before you confirm, so check it each time.

Some numbers are set by the rules of each network. Bitcoin's own rules cap the supply at 21 million coins, and its reward for miners is cut in half on a fixed schedule. You can read both in the original Bitcoin white paper by Satoshi Nakamoto and in the Bitcoin documentation at bitcoin.org. The minimum stake to run an Ethereum validator is written in the network's rules and on ethereum.org, and I will not guess it here.

Taxes matter too. In the United States, the IRS treats crypto as property. Its page on digital assets explains how sales and rewards are reported. The rules for staking rewards and mining income can change, so use the current figure, which the official source publishes each year to see the current treatment and its source. Your own numbers live in your wallet history and exchange statements. Save them.

A worked example

I want to tell you about a woman I will call Marta, because her story shows how the two systems feel different in the pocket.

Marta has 10,000 dollars set aside for a project. Suppose she looks at a proof of stake network where stakers earn 4 percent a year, a plain figure I picked for this story. She stakes 10,000 dollars. The yearly reward is 10,000 times 0.04, which equals 400 dollars. Her monthly share is 400 divided by 12, which comes to 33.33 dollars.

Now suppose the network charges her a validator fee of 10 percent of her rewards, again a made up number. Ten percent of 400 is 40 dollars. She keeps 400 minus 40, which is 360 dollars. That is a gain of 3.6 percent on her 10,000 dollars, found by dividing 360 by 10,000.

Hold on, though. The reward is paid in the network's coin, not in dollars. If the coin's price falls 20 percent in that year, her 10,000 dollars of coins is worth 10,000 times 0.80, which is 8,000 dollars. Add back her 360 dollars of rewards, assuming they hold their value, and she has 8,360 dollars. She is down 1,640 dollars, even though the reward was paid.

Compare her cousin Dale, who buys mining equipment for a proof of work coin. Say the machine costs 3,000 dollars. It uses power that costs him 90 dollars a month, which is 1,080 dollars a year at 90 times 12. If the coins it earns sell for 1,500 dollars in the year, he has 1,500 minus 1,080, which is 420 dollars before the machine's cost. After paying back the 3,000 dollar machine, he is behind.

Neither story is a forecast. The figures are mine, made up to show the arithmetic. What they show is where the money goes. Marta's risk sits mostly in the coin's price. Dale's sits in his power bill and his equipment.

Where it goes wrong

You have probably heard that one system is simply better. I would be careful with that. Each has real weak spots, and an honest person admits them.

Proof of work uses a great deal of electricity, and that is its plainest cost. It also tends to gather in places where power is cheap. Large mining groups can form, which worries people who want power spread widely. The Cambridge Centre for Alternative Finance publishes the Cambridge Bitcoin Electricity Consumption Index, which tracks the energy question over time.

Proof of stake uses far less power. Its worry is of another kind. Those who already hold many coins can earn more, so wealth can pile up. Staking can also lock your coins for a while, and getting them out may take time. Slashing is real, so a mistake in running a validator can cost you coins. Many people avoid that by staking through a service, but then you trust the service. Trust again.

Both systems face the danger of a majority attack, where one group gains control of over half the power or stake and rewrites recent records. It is costly, but not impossible on small networks. Smaller coins are weaker here than large ones.

There is also the plain risk of scams. Anyone promising fixed returns from staking or mining deserves a hard look. The Securities and Exchange Commission and the Federal Trade Commission both publish warnings about crypto fraud on their websites. Read them before you hand over a dime.

Questions to answer before you leave this page

Can you say in your own words how proof of work keeps the record honest, and how proof of stake does it differently? Do you know which of the two the coin you care about uses, and where you can confirm it on the project's own site? What fees will you pay to send, stake, or sell, and have you seen them in your wallet before confirming? If you stake, do you understand how long your coins stay locked and what could be slashed? If you mine, have you counted your power bill and equipment cost against what you expect to earn? Have you checked the IRS page on digital assets to see how your rewards or sales get reported? Are you keeping records of every transaction, with dates and amounts, so your tax numbers can be checked later? And last, could you lose the whole amount and still sleep well?