Disclaimer – Nothing in this article constitutes legal or investment advice. Always do your own research and only invest what you can afford to lose.
This article explores the two most common methods of validating transactions and creating blocks, Proof-of-Work and Proof-of-Stake. Both are types of algorithms used by different blockchains to achieve distributed consensus. As the current blockchain platforms continue to grow and develop, the debate over which system is superior is certain to intensify, and it is helpful to have a working understanding of the differences between the two.
Proof-of-Work System (“POW”)
In a broad sense, POW is an economic measure to deter denial of service attacks (where someone spams a network so much that it becomes bogged down and inaccessible to legitimate users) and other service abuses on a network by requiring a certain amount of work from the service requester. That work is usually processing time by a computer. In the context of a blockchain, the service requested is the validation of transactions and recordkeeping of the distributed ledger in order to receive a reward, a process commonly referred to as “mining.”
The use of POW has been explored for years by many researchers in a variety of applications. We will focus on the way that it is most commonly utilized by cryptocurrencies. Within a blockchain, each block must contain a “proof-of-work” to be accepted by the network.
Most POW-based cryptocurrencies use a “solution verification protocol” as the basis for its POW system. This requires “miners” to find a number called a “nonce.” This proof is easy for any node in the network to verify, but extremely time-consuming to generate, due to a secure cryptographic hash. This hash is a complex mathematical algorithm that connects blocks sequentially and securely. Miners must try many different nonce values (usually the sequence of tested values is 0, 1, 2, 3, etc.) before meeting the difficulty target. The difficulty target is simply a measure of how long it takes for miners to find the “nonce.” Once the nonce is found and verified by the network, the new block is securely added to the end of the chain using the cryptographic hash.
Basically, the POW system rewards miners for solving complex cryptographic puzzles. Mining is essentially the process of competing to be the next to find the answer that “solves” the current block. Once a valid “solution” is found, it is very easy for the rest of the network to confirm that the solution is correct, thus achieving network consensus and adding the newly recorded block to the chain. There are multiple valid solutions for any given block and only one of those solutions needs to be found for the block to be solved.
Here is a basic visual representation of how the POW system operates, using bitcoin as an example. The client in this graphic is a miner communicating with the bitcoin network in an attempt to mine a block. The client (miner) chooses and sends a nonce, which is verified or rejected by the system. The first miner to choose a correct nonce is granted a mining reward in the form of an algorithmically predetermined amount of newly created bitcoin. This is how new bitcoins (and other cryptocurrencies that follow a POW system) are created.
The difficulty of a miner finding the nonce is adjusted every 2,016 blocks (approximately 14 days) to adjust for the network’s recent performance. The goal for Bitcoin is to keep an average of ten minutes between new blocks. For example, if there is an abundance of miners, the difficulty will be increased so that the block confirmation speed doesn’t outpace the transactions on the network. On the other hand, if the network is handling a lot of transactions, and there are aren’t enough miners, the difficulty will be decreased to allow for faster confirmation of blocks. This way, the system automatically adapts to the total amount of mining power on the network.
It’s important to realize that block generation is not a long, set problem (like doing a million hashes), but more like a lottery. Each hash gives you a random number between 0 and the maximum value of a 256-bit number. If your hash is below the target, then you win. If not, you increment the nonce (completely changing the hash) and try again.
The POW system, alongside the cryptographic “chaining” of blocks, makes modifications of the blockchain extremely hard. This is because an attacker must modify all of the subsequent blocks in order for the modifications of one block to be accepted by the network. Because new blocks are constantly mined, the difficulty of modifying a given block increases exponentially as time passes and the number of subsequent blocks increases.
Transaction fees in the bitcoin network are optional. However, miners can choose which transactions to process and prioritize those that pay higher fees. Fees are based on the storage size of the transaction generated, which is dependent on the number of inputs used to create the transaction. Once all bitcoins have been mined, miners will receive income solely through transaction fees (this is estimated to be around the year 2140).
Criticism Of The POW System
The main criticism of the POW is waste of natural resources. When the bitcoin network was small, this was not a pressing or hotly debated issue. However, the bitcoin network (and other cryptocurrencies that operate on a POW system) has grown exponentially over the last few years, raising legitimate concerns over the environmental impact of a POW system. If Bitcoin and Ethereum miners were a country, they would rank 71st in energy consumption. In comparison to a traditional credit card processing company, like Visa, Bitcoin transactions use 27 times as much energy.
In addition to being environmentally taxing, this system can be problematic for the miners as well. As the difficulty of block creation spikes because of the growth of the network and the addition of more miners, solving the POW “puzzles” begins to require significantly more energy. In the United States, the high electricity costs for an individual to mine bitcoin and other POW cryptocurrencies have pushed profits extraordinarily low. Therefore, a lot of miners have pooled resources to build large server farms for mining or have outsourced to countries with cheap, coal-fired electricity, such as China. This is both bad for the environment and has been criticized as antithetical to the ethos of decentralization, as large groups of miners (known as mining pools) begin to take over the majority of mining operations.
This is arguably unsustainable in the long term and has drawn severe criticism in recent months. There have been some attempts to rectify the seemingly meaningless consumption of resources by POW, but none of them have gained significant traction. Though POW currencies will undoubtedly continue to exist, many developers have started designing solutions to move away from this system. Currently, the most prevalent solution is called Proof-of-Stake.
Proof-of-Stake System (“POS”)
In a system that utilizes a POS algorithm, the creator of the next block is chosen in a deterministic (pseudo-random) way, and the chance that an account is chosen depends on its wealth (i.e. an individual’s “stake”). In POS cryptocurrencies, the blocks are usually said to be “forged,” or “minted,” rather than mined. Also, most POS networks create all of the coins in the beginning, with the total number of coins never changing (although there are some other versions of POS where new coins can be created). Therefore, in the basic version of POS, there are no block rewards like bitcoin. The forgers take only the transaction fees.
Proof-of-stake must have a way of defining the next valid block in any blockchain. Selection solely by account balance would result in very undesirable centralization, as the single richest member would have a permanent advantage. Instead, several different methods of selection have been devised. Some coins use randomized block selection that utilize relatively simple formulas so that each node can predict (with relative accuracy) who will win the right to forge the next block.
Other coins have implemented a system that combines randomization with “coin age,” a number derived from the product of the number of coins times the number of days that they have been held. Coins that have been unspent for at least 30 days begin competing for the next block. Older and larger sets of coins have a greater probability of signing the next block. However, once a stake of coins has been used to sign a block, they must start over with zero “coin age” and thus wait at least 30 more days before signing another block.
Also, the probability of finding the next block reaches a maximum after 90 days in order to prevent very old or very large collections of stakes from dominating the blockchain. This process secures the network and gradually produces new coins over time without consuming significant computational power. Some developers claim that this makes a malicious attack on the network more difficult due to the lack of a need for centralized mining pools and the fact that purchasing more than half of the coins is likely costlier than acquiring 51% of proof-of-work hashing power.
Criticism Of The POS System
There are criticisms of the POS model, mainly relating to potential problems in the event of a consensus failure, but those issues are a bit technical for this article. Detractors have also alleged that POS allows for centralization within the network, in stark opposition to the established ethos of the blockchain community. However, I’m not convinced that POS carries a greater risk of centralization than POW. In a POS model, people who stake more coins will naturally forge more blocks. In the POW model, whoever has more hash power will naturally receive more block rewards. Either way, whoever spends more money, whether on coins or mining equipment, will control more of the network.
To summarize, the main criticism of the “traditional” POW system, wasting natural resources, is solved by the POS method, which has been criticized for being perceived as potentially allowing too much centralization to occur. There will certainly be much debate and development in this area as blockchain governance and consensus protocols are further refined and tested.
Want to learn more about blockchain technology and the underlying concepts of cryptocurrencies? Check out Blockchain: The Beginners Guide To Understanding The Technology Behind Bitcoin & Cryptocurrency (The Future of Money) from Amazon.