Why Proof-of-Stake (PoS) Leads to Centralization

In January 2020 a EU regulator demanded a ban on proof of work Bitcoin mining. He was criticizing the energy-intensive system used to mine Bitcoin. He presented the Proof-of-Stake method as a good alternative to Proof-of-Work mining. Nevertheless, Proof-of-Stake mining is very likely to lead to centralization and this is the exact opposite of what Bitcoin had intended to achieve.

Proof-of-Work (PoW) is a mechanism Bitcoin uses to create blocks that are attached to the blockchain. Because the SHA-256 hash function is random, it guarantees fairness and honesty. Proof-of-Work also decentralizes Bitcoin because it incentivizes miners to belong to no organization that could have control over their activity, but also to be geographically decentralized. Bitcoin is safe thanks to its underlying mechanism. Yet due to its decentralization, it represents a threat to centralized systems, such as banks.

There are some alternative cryptocurrencies that use another consensus mechanism than Proof-of-Work, and this mechanism is called Proof-of-Stake (PoS). It is not as energy-intensive as Proof-of-Work, because the cryptocurrency is locked in a smart contract on the blockchain. With this mechanism, instead of miners, we have stakers. Stakers have funds locked up in a special smart contract. The stakers who can create new blocks are selected by a special algorithm via lottery, according to each staker’s percentage of the total staked funds. The more funds are controlled by a staker, from all staked funds on a given network, the higher his chances are to mine the next block.

Staking isn't available for all types of coins. Bitcoin for example does not use this model. Some of the coins that use the Proof-of-Stake system are Ethereum, Polkadot, Solana, or Cardano. Staked coins still belong to you and if you decide to stop staking, you can unstake them. Nevertheless, you should keep in mind the fact that according to your smart contract, the unstaking may not be immediate. You might have to stake coins for a specific amount of time. When staking, new coins are minted and offered to the validator as a reward whenever a new block is added to the blockchain.

With the Proof-of-Stake system people, who own large amounts of cryptocurrency, control the network. And by staking, they will gain more and more of the coins. This in turn can lead to the centralization of funds in the hands of institutions that manage those funds, such as exchanges. With this type of mechanism, control of the network is determined only by capital. If someone owns more than one-third of the tokens, they are given more power because they are more likely to be selected to mine. This is not fair towards other stakers and it has the tendency to centralize because only a few dozens of validators will actually participate in mining new blocks; this allows for manipulation and collaboration on the network, and thus makes the network unreliable.

This cannot happen with Proof-of-Work. Here Bitcoin owners can’t influence the network, which is controlled solely by nodes and miners.

There are also other risks involved in staking, than just the risk of centralization. In certain situations, you can lose the coins you have staked. This can happen if you fail to validate or when you go offline. Another disadvantage of this system is the relatively high amount of money you have to use for staking. You need for example 32 ETH if you want to become a full validator. That is about 3036.72 USD, and it is an amount of money that you should be ready to lose if something goes wrong. The amount of ETH needed to join a staking pool is nevertheless much smaller, but your earnings will also be lower and you still risk losing all or just some of this money if someone within the pool does some malicious transactions. Another aspect to be taken into consideration is the fact that the Proof-of-Stake method is relatively new. Therefore it hasn't yet been fully tested and this is why it may not be as secure as the Proof-of-Work system. With this new consensus algorithm, hackers have already found bugs and they managed to use coins that had already been spent or have created new coins out of thin air.