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Along with decentralization and self-custody, consensus is a buzzword amongst blockchain buffs. If a crypto project wants to succeed, it must have a reliable way to verify and record transactions without a third party. To solve this problem, engineers developed a few intricate incentive systems.
While each blockchain puts a unique spin on consensus, the protocols tend to fall into one of two categories:
- Proof of stake (PoS)
- Proof of work (PoW)
Understanding these consensus mechanisms could give investors greater insight into how their favorite tokens function.
Proof of Stake vs. Proof of Work
Although many crypto enthusiasts are partial to PoS or PoW, these consensus mechanisms each have unique features. Knowing more about how these systems work may help investors determine which coins they’d feel comfortable using.
What Is Proof of Stake?
Proof of stake is the new kid on the “block,” but it has become an increasingly popular choice.
First proposed in the early 2010s, this consensus mechanism doesn’t require as much energy as older proof of work blockchains. Instead of making computers solve math problems, proof of stake networks encourage people to participate in the validation process by putting their tokens on the blockchain.
When people choose to “lock” their coins on a blockchain, they earn the privilege of participating in the transaction process. This means everyone who stakes tokens has a chance to produce a new block, and thus reap those tempting token rewards!
The more native tokens people lock on a blockchain, the fewer there are floating in the open market and the more secure the network should be. Also, since there’s no need to expend as much energy to create new blocks, proof of stake is considered the “cleanest” consensus mechanism.
PoS systems are considered less risky in terms of a potential network attack, as well as, more scalable by reducing transaction times.
How Does Proof of Stake Work?
“Staking” a cryptocurrency essentially means locking tokens on a project’s blockchain for a set amount of time.
Every crypto project has unique stipulations for how long and how much you need to stake to become a validator node. If you meet these requirements, you could send your crypto into the native blockchain.
Once you place your tokens on the blockchain, you’ll help secure the network, stabilize the token’s price, and function as a validator node. The proof of stake protocol chooses from the various “stakers” to validate the next block. As long as you fulfill your duty as a validator, you will receive token rewards.
Generally, the more tokens you stake on a blockchain, the higher likelihood you will get to validate new blocks. However, some proof of stake coins use randomized mechanisms to make reward distribution more equitable.
A significant benefit of proof of stake networks is that they’re “greener” than proof of work systems. While proof of stake still requires computational power, it’s not as energy-intensive as Bitcoin mining.
Interestingly, scientists at the Ethereum Foundation estimate proof of stake networks use 99.99 percent less energy versus proof of work chains.
Technically, proof of stake cryptos don’t have “miners.” Many proof of stake cryptos “pre-mine” their tokens. The people on these PoS networks are staking pre-bought coins rather than mining new coins into existence.
Arguably, this system makes it easier for average investors to participate in proof of stake blockchains versus proof of work. All investors need to do is buy their chosen token and agree to the network’s stipulations.
However, the cost to become a validator node is usually pretty high. PoS networks deliberately make these requirements costly to ensure validators have plenty of “skin in the game.” Plus, even though validators stand to gain more rewards, they carry greater responsibilities on their shoulders.
Therefore, most small investors who stake crypto “delegate” their coins into a validator pool. The validator you choose will stake the crypto on your behalf. In return, you will get a cut of the mining rewards paid out in interest.
Also, validators on a PoS network may get to vote in network upgrades. Typically, the validator will vote on your behalf if you delegate your tokens.
It’s also worth noting many proof of stake chains have pre-delegated validators. Typically, these pre-screened validators are big investors, partner companies, or official developers. While this often improves a proof of stake coin’s speed and scalability, it can increase the risk of centralization.
In a proof of stake system, the protocol will assign new blocks to validators. Usually, the more tokens a person stakes, the more likely they will validate blocks and earn staking rewards.
However, many PoS chains use random functions to make it harder for large stakers to hog all the rewards. Some networks also reward people who’ve been staking for the longest time. The reward distribution will vary depending on which blockchain you’re using.
Some critics argue it’s easier to corrupt a proof of stake network than a proof of work chain.
First off, there’s a lower barrier to entry to join a proof of stake blockchain. You only have to stake tokens to become a validator, whereas proof-of-work miners have to buy and operate expensive computers.
Also, proof of stake networks could have a greater degree of centralization. As mentioned above, people who stake more tokens usually enjoy greater rewards and voting rights. Also, many proof of stake coins use centralized cloud providers for storage.
That being said, developers are implementing many new measures to deter bad actors and increase decentralization. For instance, many proof of stake networks will “slash” validators that put out false transaction data. In these cases, validators and delegators could lose all of their crypto.
Also, a few decentralized cloud storage companies offer ways to store transaction data without relying on Big Tech companies. For instance, projects like Arweave are helping blockchains like Solana store data in a decentralized manner.
So, while proof of stake coins have security concerns, a few innovative mechanisms could increase their security down the line.
Pros of Proof of Stake
- More eco-friendly than proof of work
- Typically has higher transaction speeds and lower fees
- Easier to reach consensus on upgrades thanks to decentralized governance
- Average investors could easily delegate tokens for interest
Cons of Proof of Stake
- Larger token holders often enjoy higher perks and voting rights
- Higher barrier to entry to become a validator
- Often reliant on third-party cloud companies for ledger storage
- Staked interest is taxable, even if the underlying token goes down
Although proof-of-stake isn’t as old as proof-of-work, it appears to be the preferred choice with current crypto developers. While proof-of-stake has centralization concerns, more people are willing to make that trade-off for greater efficiency.
Here are a few of the hottest altcoins that use a proof-of-stake mechanism:
- Solana: Created by Raj Gokal and Anatoly Yakovenko, Solana is one of the fastest smart contract platforms in the crypto industry.
- Chainlink: Chainlink is an Ethereum-based project that has become the largest decentralized oracle in cryptocurrency.
- Cardano: Like Solana, Cardano is a new smart contract platform competing with Ethereum.
- Polkadot: Similar to Cardano, Polkadot is a smart contract “Ethereum killer” founded by a former member of the Ethereum team.
- Polygon: Formerly called Matic, Polygon uses proof-of-stake to make interacting with the Ethereum main chain cheaper and faster.
What Is Proof of Work?
Interestingly, the ideas that underlie proof of work were initially developed to cut down on annoying junk emails. However, in 2008, the mysterious Satoshi Nakamoto suggested this consensus mechanism may help create a decentralized digital currency. And just like that, Bitcoin was born!
Proof of work uses mathematical puzzles to confirm transactions on the blockchain. Computers on a proof of work network compete to solve this tricky problem every few minutes. Whoever wins the mini-competition gets the right to “mine” the next block and rake in the token rewards.
Although environmentalists often have issues with proof of work, there are benefits associated with this system.
PoW systems at scale require large amounts of energy to process transactions, however, they are considered to be more reliable.
How Does Proof of Work Work?
Proof of work is a competitive consensus mechanism. People who want to participate in a proof of work blockchain have to give over some computing power to their chosen crypto. In exchange for this energy, “miners” have the chance to create new blocks and earn rewards.
In the case of Bitcoin, there’s one new test about every 10 minutes. The computer that guesses the correct number the fastest will get paid in Bitcoin. This winner will also broadcast the latest transaction on the Bitcoin network, which other participants will validate.
As more computers join a proof of work network, the difficulty of these algorithms steadily increases. This dynamic difficulty mechanism helps keep cryptos like Bitcoin churning out blocks at a consistent 10-minute rate.
The more computing power people use, the better will their chance be of getting those juicy mining rewards. However, as the hash rate increases on a blockchain, it becomes increasingly challenging to solve problems—which requires even more computing power!
As you can imagine, environmentalists aren’t keen on this incentive system. Although miners should gravitate towards renewable energy to cut down their operating costs, it still requires more power than proof-of-stake networks.
According to Harvard Business Review, Bitcoin mining currently consumes about 110 terawatt-hours per year. For context, that’s equivalent to Sweden’s average annual energy usage.
On the flip side, there are many novel ways miners are using renewable energy to power their ASIC rigs. Most famously, El Salvador is experimenting with volcanic steam to mine Bitcoin. Companies like Intel are also developing novel technologies to make mining cryptocurrency more eco-friendly.
As research and technology into proof of work increases, it may spur unlikely “green” innovations.
Theoretically, anyone could start mining coins like Bitcoin on a laptop. You could have earned quite a few Bitcoins on a standard computer back in the day.
However, as the price of Bitcoin increased, competition became increasingly fierce. Manufacturers started putting together powerful ASIC rigs specifically designed for mining.
Currently, mining prominent PoW coins like Bitcoin is a big business. Publicly-traded companies and “mining farms” use hundreds of thousands of rigs to solve problems on many PoW networks.
The only way an “average Joe” could mine Bitcoin is to invest in ASIC rigs and join a Bitcoin mining pool. However, please remember that the rewards in these pools are proportional to your energy contribution.
Every computer in a proof of work system could snag the block reward, but the most advanced units have the best shot of winning. How much the winning miner gets depends on the crypto’s pre-arranged reward schedule.
For instance, Bitcoin cuts its rewards in half after every 210,000 blocks (or about four years). The initial reward for a successful block was 50 Bitcoin, but that reward shrunk to 25 in 2013. By 2020, the block reward went down to 6.25 Bitcoins. These rewards will keep going down until all 21 million Bitcoins are mined.
One concern some people have with this setup is how to keep miners motivated without a block reward. While miners could still earn transaction fees, these may not be enough to encourage people to contribute to the network.
While it’s possible a group of malicious actors could override proof of work networks, that would be a rather costly enterprise. Proof of work miners need to invest significant money in electricity and ASIC rigs. Also, since proof of work networks don’t rely on the cloud for storage, it’s easier to screen out funny business on the blockchain.
Plus, proof of work has a longer track record for success versus proof of stake.
While this doesn’t mean criminals can never take over PoW coins, it becomes less likely as the network grows to a size like Bitcoin’s.
Pros of Proof of Work
- Enhanced security and decentralization
- Fair launch proof of work tokens usually have a more equitable coin distribution
- A longer track record for success
- May encourage innovation in the renewable energy sector
Cons of Proof of Work
- High energy output
- Usually has higher fees and slower transaction speeds
- More challenging to scale and achieve decentralized governance
- Unclear how to maintain proof of work when rewards disappear
Proof of Work Coin
Proof of work isn’t as flashy as proof of stake, but it remains the “bedrock” of blockchain tech. Plus, since Bitcoin relies on proof of work, it’s unlikely this consensus mechanism will go away any time soon.
Here’s an intro to some of the most influential proof of work coins:
- Bitcoin: The first and most valuable cryptocurrency, Bitcoin is often compared with “store of value” assets and has been likened to “digital gold.”
- Ether: Ether tokens power the Ethereum network, the world’s first smart contract blockchain. (Note: Ethereum is in the process of changing to proof of stake).
- Litecoin: Created by former Google employee Charlie Lee, Litecoin is a faster and cheaper version of Bitcoin.
- Dogecoin: Beloved by Tesla’s Elon Musk, Dogecoin is a “meme” cryptocurrency that’s mined with the same algorithm for Litecoin.
- Monero: Monero is a controversial cryptocurrency that focuses on privacy and anonymity.
It’s difficult to say whether proof of stake is genuinely an “upgrade” to proof of work. Currently, there are hundreds of heated debates over which crypto consensus protocol reigns supreme.
However, it’s safe to say proof of stake and proof of work will remain the dominant consensus mechanisms. Developers are already investigating intricate strategies to improve these systems. As a crypto investor, it’s essential to have an understanding of how your favorite projects confirm transactions to evaluate their security, scalability, and decentralization.
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Eric Esposito is a freelance writer, editor, and cryptocurrency enthusiast. Although it took him a few years to grasp the Bitcoin revolution, Eric has become a crypto convert and long-term “hodler.” Besides crypto investing, Eric is interested in helping others understand how to safely stack sats with passive income opportunities.