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Proof of Work vs Proof of Stake
Cryptocurrencies function by relying on consensus mechanisms. A consensus in this context means a general agreement and it allows distributed systems to work together in a decentralised manner.
All blockchains need a system to validate transactions. For a centralised ledger, the control of the system lies in the hands of a centralised entity. However, for distributed decentralised ledgers there is a different way to validate transaction data, these are consensus mechanisms. In recent years, new consensus mechanisms have been invented to allow cryptocurrency transactions on the blockchain to agree on the state of the network; each with its pros and cons. Today we will be discussing some of the major types including proof of work and proof of stake.
Nodes are computers that run the blockchain’s software to validate and store the complete history of transactions on the network. Anyone can set up a node by downloading the blockchain’s software anywhere in the world! That is what makes the blockchain decentralised.
As of 19th September 2022, the Ethereum network will merge into ETH 2.0 which will integrate a Proof of Stake algorithm (link to the article); currently, Ethereum uses a Proof of Work algorithm.
As of 19th September 2022, the Ethereum network will merge into ETH 2.0 which will integrate a Proof of Stake algorithm (link to the article); currently, Ethereum uses a Proof of Work algorithm.
The idea of the proof of work algorithm, which is the first consensus mechanism, was introduced in 1993 to tackle spam emails. However, it had not been used effectively until Satoshi Nakamoto introduced it as the consensus mechanism for Bitcoin in 2009. Proof of work algorithms works by having all the nodes solve a cryptographic puzzle, the first one to find a solution gets the rewards. Proof of work gives more rewards to people with better and more equipment, to increase their chances, miners come together to form a mining pool and distribute rewards evenly. As a result, mining becomes centralised and uses huge amounts of electricity. This has come under heavy criticism for being bad for the environment.
To tackle the issue mentioned with the Proof of Work algorithm, a new and improved algorithm was developed. 1 validator is chosen randomly to validate the next block instead of letting them compete against each other. Not everyone can become a validator. To become a validator, nodes have to deposit a certain amount of coins into the network as a stake, this could be considered a security deposit. The larger the stake is, the greater the chance of being selected as the next validator. Staking is also used as a security measure because validators lose a part of their stake if they approve fraudulent transactions. When a node stops being a validator, transaction fees and the stake are sent back to them after a certain period.
The process of creating a new cryptocurrency is called minting instead of mining in the proof of stake algorithm.
Validators receive reward fees that are associated with each transaction they validate.
There are significant differences between the proof of work and the proof of stake algorithm. Proof of work uses more energy and is considerably more centralised. Mining pools control blockchain and that may have disruptive effects. If they come together they may control more than 51% of the transactions on the blockchain and approve fraudulent transactions. To prevent this, the proof of work algorithm rewards the miners less over time to decrease the incentive for an attack. If BTC were to work with proof of stake, to make a 51% attack, validators would need to stake $226,018,979 worth of BTC - at the time of writing - into the network. This makes it less likely to suffer from an attack.
However, proof of stake doesn’t come as a perfect solution for minting. The election process for the next validator can not be random because the amount of stake has to be factored in as well, however, this would lead to validators who own more money than the others receiving more rewards. Another risk would be that a chosen validator is not doing their job. There are solutions to these risks such as coin age-based selection and backup validators.
Proof of work and proof of stake are the building blocks of the crypto and blockchain ecosystem. New algorithm projects that address the pain points and make the ecosystem safer and more secure are in development. Blockchain technology is adapting and it’s exciting to see the evolution over the past few years, and who knows what exciting developments we will see in the next few years?