Proof of Work and Proof of Stake Coin Distribution and Centralization

Here’s a look at some of the game theory in how a proof of work coin and a proof of stake coin might play out.

Disclaimer

This article doesn’t try to be a comprehensive comparison of PoW (Proof of Work) and PoS (Proof of Stake). Rather, it focuses more narrowly on some of the issues in PoS that I’ve noticed and how this compares to PoW. So don’t read this article thinking that I’ve covered everything, I haven’t!

Introduction

The aims of cryptocurrencies in general is to maintain or enhance technologies that we already have, but in a decentralized manner. This means that we must examine every aspect of blockchain technology in detail. We must evaluate its game theory to judge whether it will be able to sustain itself in a decentralized way… Because if it can’t, there’s probably no point for its existence in the first place. It might as well have just been another App built on AWS servers.

Prior Knowledge

If you’re unconvinced or curious about why decentralization is important, you might want to check out this article.

This article assumes knowledge about consensus on a blockchain and the basics on how PoW and PoS work.

Proof of Work

Proof of Work isn’t free, it requires energy because physical computers are doing real work, generating and testing tens or hundreds of terra-hashes every second until someone finds a valid hash. This expenditure of energy means expenditure of money, not just on the energy but also the equipment that expends the energy. But of course there is money to be made in mining these coins. An industry is born.

A capitalist (in the sense of someone with capital looking to invest) might see that they could mine a Bitcoin for the cost of 10,000 (made up figure) but earn 50,000. A great deal, one that they should invest in. Over the course of a few years, thousands of capitalists grapple with this same calculation and invest. Even if it costs $40,000 to mine a Bitcoin it still has a positive outlook (especially if you expect for the price of the coin to increase).

Competition, Antithetical to Profits

Over time, the hashrate of the Bitcoin Network increases, which increases the competitiveness and thus the cost of mining a Bitcoin. Eventually, the brutal competition of a free, open and inherently global market will mainly eliminate profits. If there are laws in country A to try to stifle competition (perhaps regulatory capture or just a straight ban) then more competitive mining operations will appear in country Z. Country A will be harmed with no upside (lost revenue), game theoretically this doesn’t make sense but of course laws that don’t make sense pass from time to time.

Let’s say eventually it costs 40,000 to mine a Bitcoin at a price of 50,000. On average, assuming no leverage or loans, the miner will have to sell 80% of their newly minted Bitcoin just to keep the lights on in the mining facility. Remember, they must pay for the electricity they use and pay to maintain the facility they’re operating in. What effect does this have? Well it allows for new Bitcoin to be distributed across the population rather than it simply accruing in the hands of the investors. A decentralizing force.

Proof of Stake

Proof of Stake is a much cleaner approach, it doesn’t require any significant amount of work for it to operate, it doesn’t require the manufacturing of ASICs for its security model, it doesn’t require large amounts of energy. It aims to simulate proof of work without any of the baggage.

In PoS, someone can stake their coins and earn interest. The idea is that the staked coins can be taken off of bad actor so there’s an incentive to not be bad. So long as the majority of the coins that are staked belong to good actors then the blocks produced should be sound. The interest paid is to incentivise people to stake their money in order to increase the security of the network.

Incentives

The trouble is that there is no incentive for people to ever sell their staked coins at this point in time. Of course they might want to take some short term profits but the long term outlook of someone bullish on crypto is that time in the market is the way to go. So, they just keep accruing free coins with no costs associated. This means new coins will just accrue to those who already have coins rather than to increase liquidity for newcomers trying to get a reasonable share of the pie.

This issue is compounded in the case of Ethereum as the minimum amount of ETH to stake is 32 ETH, worth about 115,000 at the time of writing! This means you must have 115,000 available to invest before you can benefit off of the monetary expansion and transaction fees from Ethereum. You might argue that it’s not free to start gaining from Bitcoin however this goes back to the point that the new coins will be distributed around much more and over time the profit margin will narrow.

Additional Comparisons

Premines

There is also the premine issue. A premine is when a group of people gain a share of the coins before the public are allowed to participate in the network. Depending on how large the premine is and how many coins are sold to the public, this can lead to a very lopsided coin distribution. In PoW it doesn’t really matter how a coin is distributed as it pertains to consensus and integrity of the network. This is not the case in PoS, where coin distribution is everything. As a reminder, 51% of the coins control the consensus of the network. Those who control the coins control the network. So one large entity controlling a large amount of the coin supply is quite a big centralization risk due to the influence they have in the network.

Ability to Change

Here’s another way of looking at what I’ve presented thus far. If we take for example a PoS coin with a supply cap of 10bn but an entity has 3bn of those coins, there is nothing anyone outside of that entity can do to oust that 30%. They have a large influence forever, unless they decide to cash out. Even for a coin without a supply cap, the new coins are issued to those who already have coins so it doesn’t automatically distribute to newcomers. By comparison, in PoW, a miner with 30% of the hashrate could realistically become a tiny part of the hashrate within a few years as hundreds or thousands of additional miners enter the fray.

Conclusion

The main thing I’d like you to take away from this is not that I think proof of stake is a complete waste of time and is terrible, or that proof of work has no drawbacks whatsoever. I’m merely trying to show that there are trade-offs, it’s vitally important that we assess these trade-offs honestly rather than dogmatically spout that there’s been an ‘innovation’ that solves all of the problems of the previous system with no drawbacks of its own. We’ve seen this play out so many times when it comes to scaling. A new project will argue that they’ve found some breakthrough way of scaling a chain without sacrificing security or decentralization when this has never truly been the case on the base chain, L2 appears to be a different story.