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Cryptocurrencies as we know them today owe their success to the various financial incentives which underlie their various consensus mechanisms. Most consensus mechanisms that are used widely fall into the categories of proof-of-work or proof-of-stake. There are many other mechanisms, but in the cryptocurrency world, the two are the most common. In this article, we would analyze and compare both of them. To understand where proof-of-work or proof-of-stake fit into the picture, first, we need to understand what a consensus is –
We all know by now that blockchains are a type of distributed ledger database that maintains a continuously growing list of transaction records ordered into blocks with various protections against tampering and revision. In simple words, it’s a chain of blocks that contain transaction data that cannot be tampered with. Contrary to popular belief, blockchain technology has existed long before Bitcoin was invented. Satoshi Nakamoto just figured out how to use blockchain to create a form of digital money. The biggest problem with money that he solved was the double-spend problem. If a form of money could be spent twice, even if it happened once in one million times, it would be a catastrophic failure.
In any decentralized or distributed system where no member can identify another, there’s an inherent problem. There are many actors in the system, some of which can possibly be acting against the interests of the network. In order for a network like a blockchain to work, every single actor has to agree on the same version of the truth at all times. If there are conflicting versions of the truth inside of a network being used as digital money, it can lead to double spending of the same money, among many other problems. This problem is called the Byzantine Generals Problem. How do you know for sure whose version of the truth is the real one?
To solve this problem, we need a mechanism that can be used to ascertain one version of the truth that everyone agrees on. That mechanism is called a consensus mechanism. In a democratic country, the consensus used is voting where each person’s vote has equal weightage. In cryptography, there are many different ways of reaching consensus with varying degrees of success in different situations. One of them is proof-of-work.
What is proof-of-work?
The concept of proof-of-work was pioneered by Hal Finney in 2004 through the idea of “reusable proof of work” using the SHA-256 hashing algorithm. It was later adopted by Satoshi Nakamoto as an integral part of the Bitcoin network. Finney was also the first ever person to receive a Bitcoin transaction, presumably from Satoshi Nakamoto themself.
Satoshi managed to solve the Byzantine Generals Problem by using a proof-of-work mechanism in order to establish a clear, objective ruleset for the blockchain. In order to add information, called blocks, to the blockchain, a member of the network must publish proof that they invested considerable work into creating the block. The work consists of each computer trying to make the correct guess for an extremely random number, getting more complex with time. This work imposes large costs on the creator, and gets increasingly cost-intensive with time, thus incentivizing them to publish honest information.
Because the rules are objective, there can be no disagreement or meddling with the information on the Bitcoin network. The ruleset governing which transactions are valid and which are invalid is also objective, as is the system for determining who can mint new bitcoin. Additionally, once a block has been added to the blockchain, it is impossible to remove without creating a new version of the whole chain of blocks, making Bitcoin’s past immutable.
However, proof-of-work does have some drawbacks. The biggest one is that since the protocol consumes increasingly large amounts of energy, there are a lot of environmental concerns. The Bitcoin network consumes more energy than many small countries like Ireland and The Netherlands. Even though about 80% of the energy used in Bitcoin mining is green energy, according to a report from 2018, it is still a lot of energy used, which people outside the crypto community may consider a waste.
Another problem is the possibility of a 51% attack. The attack refers to a situation where malicious actors gain access to more than 50% of the network, at which point they can stop new transactions from being approved or double-spend the money, resulting in a collapse of the entire network. At this point, it’s nearly impossible to conduct a 51% on the Bitcoin network, but some other smaller blockchains that use proof-of-work are much more vulnerable. This website keeps track of proof-of-work blockchains and how much it would cost to conduct a 51% attack on their network.
There are, however, other types of consensus protocols that solve these problems and more. One of them, which is gaining popularity fast, is proof-of-stake.
What is proof-of-stake?
Proof-of-stake was first proposed on the Bitcointalk forum in July 2011 by the user QuantumMechanic. It has grown to be the consensus protocol of choice for most new blockchains coming out today. Even Ethereum is all set to move its current proof-of-work consensus protocol to proof-of-stake with their rollout of Eth 2.0.
In a proof-of-stake consensus mechanism, instead of using large amounts of computing power and energy to solve an equation, a cryptocurrency coin is staked or locked up in a pool on the blockchain to earning the right to process transactions. The length of time a cryptocurrency must be staked to process transactions can vary, as can the minimum amount of tokens a node must lock up as a stake. Logically, the more cryptocurrency you stake, the more likely you are to process transactions and create a block. Every version of an implementation of proof-of-stake also has some sort of mechanism to randomize who gets selected to approve the transaction, otherwise, the biggest staker would get to approve every single transaction.
Why are new projects increasingly choosing PoS over PoW?
There are some considerable advantages proof-of-stake has over proof-of-work. The biggest one is security. PoS structures compensation in a way that makes an attack less advantageous for the attacker. In order to conduct a 51% attack, someone would have to buy 51% of the supply for that cryptocurrency. It is already incredibly difficult to acquire 51% of the entire supply for any reputable cryptocurrency at all, but even if someone did manage to do it, they wouldn’t have any incentive to harm the network they practically own and control.
Proof-of-stake is also much more energy-efficient since it completely removes the energy-intensive mining process. As factors like climate change affect our world, energy efficiency is going to be more and more important even for important technology.
They do, however, cause a tendency to move towards more centralization. Since proof-of-stake creates a rewards and punishments system in order to incentivize the required behavior from nodes, it does mean that the issuing organization for the cryptocurrency has more control over the network compared to proof-of-work, which goes in the opposite direction from a very important principle of decentralization in the crypto world.
There are many other forms of consensus mechanisms that use a different system to approve and verify transactions like proof-of-capacity, proof-of-identity, designated proof-of-stake, proof-of-activity, and others that are used by different blockchains, but none of these have achieved the same levels of adoption compared to proof-of-stake and proof-of-work. Neither of these are perfect, but the crypto world seems to be heading strongly in the direction of proof-of-stake.