Something I have been thinking about since the last blockchain event I attended regarding proof of stake is this:

The tokens need to be staked to secure the system, for that, users who choose to do so receive compensation in that same token. From what I’ve been looking at, the rewards can come from different sources depending on the particular implementation of POS (every blockchain works slightly differently).

A percentage always comes from fees, which of course means, the blockchain with more usage will generate more revenue. And in some cases the tokens have inherent inflation to subsidise block rewards.

If the token has inherent inflation this could be a massive problem, since it will create downward pressure on its value. One must also assume that validators earning tokens will sell some to collect profits, adding to its pressure. This means that the bet you’d be making is that the usage of the platform (the fees) will be greater than this combined downward pressure. This could be ok during bull cycles, but left us wondering how the system will react to a bear market.

If you are a validator holding tokens that are depreciating, and earning on this same token, while the inflation rate remains constant and usage of the network drops. One can see an ugly outcome start to rear its head.

If validators start selling their tokens to cut their losses, the token price drops more at the same time as the security of the entire network falls. This creates further pressure for other validators to sell, resulting in a spiral where no one wants to be the last person holding the bag.

This is, of course, less likely to happen in big networks, where people continue to use the services provided than in smaller blockchains. Many of the newer ecosystems, I think, are quite fragile in this scenario. Especially since most of the activity within them is more speculative in nature and provides few real services that people need in their everyday lives.

Far is for me to tell people what to do or give financial advice (DYOR), yet personally I would be very wary of small POS blockchains.

Now let us do a comparison on a similar scenario on Bitcoin’s Proof of Work. Bitcoin also has a low inflation to subsidy block rewards (though this inflation has a hard cap so it won’t inflate forever), and miners have both costs of equipment and energy. This also creates a downward pressure, so far the usage of the network and the value appreciation of the asset have made it so that mining Bitcoin tends to get more profitable over time.

Yet we have seen during bear markets, that sometimes the token price decreases to the point where it is not profitable for miners to keep their most powerful equipment online (similar to what we describe above with POS). Here is where a key element separates both ecosystems.

Firstly, if a miner is at a loss, it is much harder for them to sell their machines, than it is for a POS validator to sell their coins (they can do so with a few clicks). This is not unimportant as it makes miners less likely to abandon the ecosystem altogether.

A miner usually acquires their gear with payment plans that can take them years to fully pay, plus the lease of the land and energy sources. All this makes them more likely to stick around through downtrends in BTC price.

Yet the most important thing to understand is the difficulty adjustment, one of the most brilliant aspects of the protocol. Once mining becomes less profitable and the miners start unplugging their most powerful machines, the difficulty of the algorithm drops. This means that now, less powerful computers become profitable to mine with. We see this in every cycle, price goes down, new miners come offline, the difficulty drops, old generation miners become profitable again and start to come back online. Through this process the system remains stable.

POW has an inherent system that makes it possible to keep the network secure even during severe price drops. Basically the difficulty will keep dropping until it is profitable for people to mine with whatever device they have, find its base, and then start growing again.

This ebb and flow has made the Bitcoin network extremely reliant and secure during its whole life span. When the network was small people could mine it with their old laptops, since the difficulty was so low.

Even when China banned mining, and the network lost a third of its hashrate suddenly. The difficulty adjustment kicked in, and everything stabilised again.

To my eyes, this design is nothing short of genius.

Through my research into POS systems I have yet to find something similar. A way to ensure systems will remain protected when the token loses value and mining becomes less rewarding.

In the case of Ehtereum (which hasn’t adopted POS yet) the idea seems to be that people will continue to use it (and pay fees) even through bear markets. To diminish the downward pressure, the token is moving to a deflationary model. Again, this is all theoretical at this stage and it is yet to be seen how it will actually work. There are other concerns here as well, with a monetary policy that keeps changing and no hard cap on circulating supply.

To me Proof of Work is hard to beat, as the system has proven to be extremely resilient and reliable.

At the end of the day, everyone is free to invest and acquire any asset they so choose. My only advice is to understand what you are buying, so that you can make an informed decision.