Proof of work or proof of stake – What’s the future of crypto?

A short guide to Crypto Index Funds
May 22, 2019
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Proof of work or proof of stake – What’s the future of crypto?

Consensus algorithms are fundamental to establishing the legitimacy of any cryptocurrency. They’re the mechanism that determines what information can and can’t be added to a blockchain, yet they don’t always get the attention they deserve.

That’s partly because their technical workings can be hard to understand. Non-specialists have likely heard about consensus but see it as blockchain’s plumbing – important to know that it works, but there’s no compulsion to dive in deeper.

They could be missing a trick. Because the evolution of consensus is one of the key drivers of blockchain innovation. Crypto enthusiasts and investors need to understand its cornerstone technologies if they’re going to make intelligent bets about where crypto is going.

What is consensus and why is it important?

Consensus algorithms sit at the very heart of blockchain. They determine everything from transaction speed, energy consumption and cost, to network security.

By dictating how transactions are ordered and verified in a blockchain’s distributed ledger, they provide a ‘single source of truth’ by vetting and approving each cryptocurrency transaction’s validity.

Cryptocurrencies have no central intermediary to confirm the identity of counterparties, so another mechanism had to be created. The notion of using a distributed network of users to play what in banking would be the payment processor role, is one of the things that make cryptocurrencies so unique.

In a consensus algorithm all the nodes have to agree on a basic set of rules, and be able to move forward by saying yes to an assessment of transaction information before it is added to a chain. That isn’t easy. Thousands of people use blockchain networks. The consensus algorithm has to process validations both anonymously, and quickly.

While nobody takes issue with using consensus protocols as blockchain’s mechanism for validation, there is an important debate underway right now about which one offers the best way to achieve it.

The original: Proof of Work

The first protocol for consensus algorithms was Proof-of-Work (PoW). It operates by requiring each validating user or miner to prove they’ve completed a complex computational action.

That stops the network from being attacked or undermined by fraudsters, and minimises the threat of cyber attack. Each miner tries to solve the problem using their computing resources. The miner who eventually finds the solution confirms the transaction and writes a new block onto the chain.

As reward for work, time, and energy spent the miner receives cryptocurrency. Bitcoin miners receive Bitcoin, Ethereum miners receive Ether, and so on. The system incentivizes miners to take part in the transaction validation process and keep the network secure.

The heavy computational exercises underlying PoW require significant amounts of electricity in order to power expensive and intensive computing hardware. For many that makes PoW wasteful, expensive and inefficient.

One study says the annual power needed to mine Bitcoin alone each year is comparable to Ireland’s average annual electricity consumption.

The Application Specific Integrated Circuits (ASICs) needed to mine cryptocurrency via PoW are advanced and expensive, excluding many people from taking part.

Most ASICs are manufactured in China, where electricity is comparatively cheap. This has led to an estimated 60-70% of Bitcoin’s total mining activity originating in China.

Beijing’s crackdown on crypto and mining may change all that – but Chinese dominance has also exposed how PoW can enable a centralization of blockchain network power– something antithetical to its founding principles.

The challenger: Proof of Stake

The proof of stake or PoS consensus protocol was developed to address the perceived inefficiency and centralization associated with Proof-of-Work. Instead of compelling cryptocurrency miners to buy costly equipment and compete to solve math problems, each miner in a PoS network first purchases the coins used by the network.

The more coins a miner holds, the more power that miner has over the ‘truth’ of the ledger. As such, selection is strongly influenced by those with the most coins – those with the biggest ‘stake’ in the network – because they have more to lose in the event of any failure, loss of information, or cyber attack.

Another influencing factor is the length of time coins have been held by users. Anyone who has invested in a cryptocurrency for long period is seen to have demonstrated commitment, and will be in a more influential position than someone who purchased coins yesterday.

PoS is also requires considerably less computational power, meaning that it is less wasteful and more cost effective. That removes a major barrier to entry for people who want to become miners and help validate transactions – the required technology can run on a standard PC.

In a proof-of-work blockchain, miners are incentivized to validate the longest chain on the ledger, as this chain will be considered the primary version of the truth and the one that earns the miners their rewards

Under proof-of-stake the low cost of entry means individual miners can potentially mine numerous ledgers at once. Hypothetically speaking, a malicious PoS miner operating on various chains could complicate how the network reaches consensus, and even manipulate the ledger’s historical record to personal advantage.

PoS vs. PoW: Who will win?

While proof of work still dominates due to being the default consensus mechanism for Bitcoin and Ethereum, proof of stake seems to be where most innovation is focused.

Ethereum’s planned Casper upgrade will see it shift from PoW to PoS, while the emergence of Delegated Proof of Stake (DPoS) algorithm promises to make the PoS protocol even faster and more efficient.

In DPoS, validation is conducted by a group of delegates selected by network users, and given dedicated network nodes for mining. Because these delegates have been hand-picked by the network, it addresses the perceived weakness of PoS — a low cost of entry that could enable unscrupulous miners to game the system.

Ona different front, Ripple has developed its own consensus protocol which allows participants to ‘crowdsource’ truth in the system based on historical information. And more consensus algorithms continue to surface, each solving problems unique to a particular application.

Cryptocurrencies continue to evolve as factors like cost, efficiency and scalability drive new blockchain use cases. As more emerge, it seems probable that the range of consensus mechanisms will do the same.

For now, Bitcoin’s dominance means PoW retains the lead, but the future seems to favour PoS.

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