Before investing in cryptocurrency, like any other investment, it is crucial to understand the basics of how it works and what makes it valuable. The best way to start is by getting a good understanding of mining and how the blockchain works. In this article, we will discover how the Proof of Work (PoW) and Proof of Stake (PoS) concepts changed the financial system forever.
When Crypto was first introduced to the world with Bitcoin, Satoshi Nakamoto had to find a way for transactions to get verified without the use of an intermediary party like Banks or FinTechs (Ex. PayPal). Being a decentralized network, Nakamoto had to make sure that no users could spend the same money twice. This problem brought us something called a “consensus mechanism,” which is a system that connects all computers in a crypto network to agree on which transactions are legitimate.
The two most widely used consensus mechanisms are Proof of Work (PoW) and Proof of Stake (PoS). For each of these mechanisms, we will go over their basic structure, how they work, and how they differentiate from each other. Understanding these basics will help you evaluate available cryptocurrencies for your portfolio, as some may come with added responsibilities or benefits.
First proposed in 1993 to fight against spam emails and stop distributed denial-of-service attacks (DDoS), the PoW concept was born. The idea was for computers to run through an additional process that verifies an email’s legitimacy before being sent. This concept was soon neglected, as it would require a lot of computing power and resources for users to send mass emails.
PoW was then brought back in 2009 by Satoshi Nakamoto, when he created the world’s first decentralized digital money system, Bitcoin. This system runs on blockchain technology, which is a mechanism that consists of a series of blocks that chronologically show transactions on a public ledger. In other words, an extremely large list available to the public that displays every single verified transaction that has happened from the very first trade on the network to present day activity. The first block on a blockchain network is called the “Genesis Block.” All subsequent blocks added to the blockchain always refer to the previous ones and each contain a copy of the full, updated ledger. But before transactions within a block can be added to the blockchain, it must be verified. This is where the PoW concept comes into play.
Proof of Work is based on an advanced form of mathematics called ‘cryptography’ hence the name ‘cryptocurrency’. Cryptography uses mathematical equations that are so complicated, only powerful computers can solve them. No equation is ever the same, meaning that once it is solved, the network knows that the transaction is authentic. This process is performed by miners who use nodes (computers that run on the specific blockchain network) in a competitive race to solve complex mathematical problems which validate blocks that meet the rules of the network. This process creates new blocks on the blockchain and is referred to as ‘hashing’. The miner that answers a mathematics puzzle the fastest, will create a cryptographic link between the current and previous blocks and earn some of the network’s native currency. In Bitcoins case, successful miners will earn BTC. To avoid tampering, the ledger is distributed, allowing other miners to reject any altered versions instantly by making sure that there are no identical mathematical solutions. The more miners there are, the more power and security the blockchain has.
PoW was the first consensus mechanism to make a decentralized currency possible and has some powerful advantages. When looking at Bitcoin, with such high value and so many miners around the world, it has used the PoW concept to become the most powerful and safe crypto software out there. Because of the processing power involved, the Bitcoin blockchain solved the double spending problem and is pretty much impossible for hackers to meddle with. On the flip side, mining for a PoW network is an energy intensive process that costs thousands of dollars a day to run. Not only does it need significant amounts of electricity to mine, but a PoW blockchain is also very limited in the number of transactions it can process at the same time. For example, Bitcoin’s blockchain can only handle around 7 transactions per second with an approval speed of around 10 minutes. The most notable issue with the PoW concept is that it provides an unfair advantage to those with the most powerful and expensive hardware devices. Because of this, most PoW mining is done by corporations with hundreds of these devices in warehouses, referred to as ‘mining pools’. As a result, other consensus mechanisms have been created to provide a fairer and more equal mining system. This brought us the Proof of Stake concept.
In 2012, we were introduced to a modified version of the PoW system with the Proof of Stake model. This concept was created by two developers named Scott Nadal and Sunny King to provide a lower energy intensive process than PoW and give miners a fairer chance of reaping the rewards gained from creating new blocks. The system still uses a cryptographic algorithm, but the objective of the mechanism is different.
Instead of having a competitive race to mine new blocks, PoS introduced a system where an algorithm elects a node to propose the next block to the blockchain. When a node gets elected, its role is to verify the legitimacy of the transactions within the block, sign it and propose it to the network for validation from other miners. Proof of Stake blockchains employ a group of ‘validators’ who are individuals and corporations that stake their own crypto in exchange for a chance of using their nodes to validate new transactions, update the blockchain, and earn rewards. The network’s algorithm chooses validator’s nodes based on the amount of crypto they have added to the pool and the length of time they’ve had it in there.
On a PoS system, the blockchain still works very similar to PoW, where transactions are added to a block on a public ledger, but new blocks are assigned instead of won. Because PoS takes the competitive factor out, new blocks are said to be forged or minted instead of being mined. Therefore, those who own nodes connected to a PoS blockchain are no longer referred to as ‘miners’, but ‘forgers’ instead.
To become a validator on a PoS blockchain, a forger must add the blockchains native currency to a specific wallet. Once coins have been added to this wallet, they are automatically frozen and used to stake the network. Most Proof of Stake networks require a minimum amount of coins to start staking. Although they will be spending way less money in block forging expenses, validators will have to make a large upfront investment to become a validator for the network. Unlike PoW where miners are rewarded with freshly minted crypto, validators are rewarded with transaction fees that users are required to pay when making a transaction. These transaction fees are also known as gas fees.
If you decide to stake coins for a PoS system, your chances of winning the reward (transaction fees) is linked to the total percentage of coins you staked. For example, if a blockchain holds 50,000 coins in circulation, and you stake 5,000, you have a 10% chance of being chosen to forge a new block and earn the transaction fees. If you are chosen, your nodes then complete the cryptographic algorithm, connecting the previous block with old transactions to the new block with recent transactions. Similar to PoW, the block is then distributed, allowing all other forgers to instantly reject any altered versions by making sure that there are no existing identical cryptographic solutions.
Mining:
PoW: Competitive race to solve each block’s cryptographic problem using miners nodes.
PoS: Assigned blocks to validators nodes to complete the cryptographic problem. Nodes have a better chance of being chosen based on the amount of coins the forger has staked.
Reward:
PoW: The node that finds the solution first is rewarded with freshly minted crypto of the blockchains native currency.
PoS: The node that is pseudo-randomly assigned to solve the problem for a new block is rewarded with transaction fees paid by transactors.
Expenses:
PoW: Miners must pay thousands of dollars a day in energy to have their nodes working around the clock to solve every single new block’s cryptographic problem (most failing to be first).
PoS: Forgers must pay a hefty startup fee to stake, but instead of using power to try and solve the cryptographic problem for every single new block, PoS nodes only have to use power to do blocks that are assigned to them.
Security
Those who stake coins to forge for a PoS system have money on the line, so they will always try their best to help keep the network as secure as possible by doing things correctly. If a forger attempted to hack the network or process malicious transactions, they would lose their entire stake.
Electricity
PoW systems cost thousands of dollars a day to run as well as being terrible for the environment. A recent study found that the total amount of electricity required to keep the Bitcoin network functional is more than the amount used by 159 individual countries! Since PoS nodes are assigned blocks, the electricity cost to verify transactions is substantially lower.
Centralization
As explained earlier, since PoW mining is so expensive and competitive, most transactions are verified and added to the blockchain by huge companies with thousands of hardware devices in a ‘mining pool’. These mining pools give them the highest chance of solving the cryptographic problem first, and those with fewer nodes will have a considerably lower chance of doing so and winning the reward. For example, with Bitcoin, there are just four mining pools in China that control more than 65% of the network’s mining power. PoS systems provide a less centralized mining process, as large groups cannot dominate the network. If a corporation wanted to forge for a PoS system, they would have to buy and then stake an enormous amount of coins.
Now that you have a better understanding of the internal basics of cryptocurrency, you can use this knowledge when evaluating available coins for your portfolio. Always remember to do research before investing and make sure you trust companies before investing in their technology. Although Proof of Work and Proof of Stake are the most widely used consensus mechanisms out there, innovations are always changing the crypto industry and new mechanisms will arise. An important project to keep an eye on is Ethereum, who are building an entirely new blockchain (Ethereum 2.0) that uses PoS instead of PoW. If you want to learn about more concepts in the crypto industry and stay updated on new innovations, visit our blog page.
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