Studying Level 1 Alt Investments , you’ll come across the terms ‘Proof of Work’ and ‘Proof of Stake’ in the context of blockchain and digital assets. These terms are central to how cryptocurrencies like Bitcoin and Ethereum operate securely without a central authority.
What do these terms actualy mean?
The CFAI notes are a bit vague here, so I wrote this post to break it down a bit…
What problem are these mechanisms solving?
Blockchains are decentralized. That means there’s no single entity (like a bank) confirming whether a transaction is valid or not. So how do we prevent fraud, like someone trying to double-spend the same coin?
You need a way for the network to agree on the true version of events. In crypto slang this is known as “consensus.” Both Proof of Work (PoW) and Proof of Stake (PoS) are consensus mechanisms – ie systems that make sure everyone agrees on which transactions are legitimate and get added to the blockchain.
Proof of Work (PoW)
How it works:
> Miners compete to solve a complex mathematical puzzle.
> The first one to solve it earns the right to validate the next block of transactions.
> As a reward, the miner receives newly minted coins plus the transaction fees associated with that block.
Imagine a shared ledger where anyone can propose the next entry, but only if they win a speed math contest. The cost of solving these puzzles (in energy and equipment) makes it too expensive to cheat.
This process requires significant computing power and energy.
For example Bitcoin uses PoW. It’s extremely secure, but also extremely energy-intensive. (Estimates suggest that Bitcoin’s network uses more electricity than some small countries).
Proof of Stake (PoS)
How it works:
> Validators are chosen to validate transactions based on how much of their own cryptocurrency they have staked (locked up).
> The more you stake, the higher your chance of being selected.
> Honest validators are rewarded with new coins and possibly transaction fees. Dishonest validators can have their stake slashed, meaning they lose part of their funds.
Think of it like a collateralized voting system. To submit the next ledger entry, you have to put down a security deposit. If you’re honest, you earn interest and keep your deposit. If you cheat, your deposit is confiscated.
This process consumes much less energy and is more scalable.
For example Ethereum transitioned from PoW to PoS in 2022. The result was a greater than 99 percent drop in energy usage and a move toward more scalable, sustainable infrastructure.
What’s the Actual Benefit of Validating Transactions?
The notes are thin in properly explaining this, but it’s important to note that In both systems, validating transactions is profitable.
In PoW ‘Miners’ receive block rewards and transaction fees. The process is expensive (electricity, specialized hardware), so only efficient and honest miners survive.
In PoS ‘Validators’ earn a staking yield depending on the network. If you act maliciously, you lose your staked coins (via slashing), which keeps validators honest.
The incentive to validate comes down to economics.
Validators get paid to help maintain network security. And they risk losing money if they misbehave. The system relies on rational economic actors.
What to know
You don’t need to become a blockchain engineer.
But you should be able to:
> Understand the mechanics behind decentralized trust
> Evaluate tradeoffs between security, scalability, and sustainability
> Analyze crypto as an investable asset class, including how its infrastructure affects long-term value
> Recognize how incentives drive system behavior, just like in traditional finance
These mechanisms are economic systems designed to align participant behavior through reward and risk.
Final thought
Both Proof of Work and Proof of Stake aim to create trust in a trustless system. PoW is proven and secure, but energy-hungry. PoS is efficient and growing, but still relatively new.
