Consensus Mechanisms: Proof of Work vs. Proof of Stake
Introduction
Consensus Mechanisms. Mining. Proof of Work. Validation. Proof of Stake. Algorithms. Hash functions. 51% attacks.
Confused yet?
Behind almost every cryptoasset lies a consensus mechanism. While the actual process might vary from token to token, the reason for each stays the same. These mechanisms are in place in order for the network to reach consensus on all new information and transactions being added to the ledger. With all of the network on the same page (reaching consensus), this ensures that the next block being added to the chain consists of the most recent and valid transactions of the network. The reason this is so important is that it prevents malicious activity such as double spending, a 51% attack, and invalid data from being entered and encoded within the chain.
The two most prominent blockchain consensus methods are that of Proof of Work (PoW) and Proof of Stake (PoS). The main difference between each method is in how they delegate and reward those who assist in validating the transactions occurring on the network.
Proof of Work (PoW)
Pioneered back in 2008 with the introduction of Bitcoin, the Proof of Work method of reaching consensus involves a network of third parties (miners) providing “work” in order to validate transactions and secure the chain. The process of mining Bitcoin is as follows.
- 1Network participants broadcast transactions to the public network
- 2These transactions are bundled together in what is called a mempool (memory pool)
- 3 Miners then verify each and every transaction within this mempool by solving and computing complex mathematical “puzzles”
- 4 The first miner to successfully solve the puzzle is rewarded with what is called a block reward. In this case, that miner will receive newly minted Bitcoin as well as any transaction fees associated from step one.
- 5 This newly verified mempool (now called a block) is added to the public blockchain and the miners move on to the next bundle of transactions
The puzzles these miners are solving are asymmetric, that is they are difficult to solve yet easy for others to verify once done so. Because they require brute force to solve – meaning no specific skill set – the only way to increase one’s odds of being the first to solve the puzzle is to increase one’s computational power. In recent years, we have seen manufacturers such as Bitmain release machines, called Application-Specific Integrated Circuit (ASIC) miners, whose sole purpose is to solve these computational puzzles.
The primary reason for the inherently difficult nature of these puzzles is to deter an individual or group of individuals from acquiring a majority of the total network hashrate (computational power). This is commonly referred to as a “51% attack.”
The above graph depicts the current hashrate distribution as of 5/30/2018.
Furthermore, an important aspect about these so called puzzles is that the difficulty of them can be adjusted periodically. Currently, the Bitcoin protocol aims to have one block solved every 10 minutes. If for example, over a span of a few weeks the average block time has decreased to 8 minutes, the difficulty will automatically increase to bring that average time back up to desired levels. This also means that if it is taking, on average, longer than 10 minutes to solve each block, the algorithm will decrease in difficulty. This constant rebalancing of block times and network difficulty results in a delicate, yet important relationship between the network and miners.
Miners will seize the opportunity to mine a chain whose difficulty has been recently adjusted to be easier, as this means it is usually more profitable for them to dedicate their hash rate to validating this chain. This arbitrage opportunity won’t last for long as more and more miners begin to switch over. Over time, the algorithm will detect a higher hashrate – leading to faster block times – and readjust accordingly, bringing the difficulty back to equilibrium levels.
The opposite effect holds true if the difficulty increases. Miners might reallocate their computational power to more lucrative chains, thus decreasing hash power on the network and in turn increasing the average block time overall. As you might have guessed by now, this will result in the difficulty readjusting itself again in the future.
Individuals allocating their computational resources to an activity such as Bitcoin mining are not doing it for free, but require a return on their investments. Miners need to recoup their costs of operations, including but not limited to: electricity, initial capital investments in computing hardware and software, and depreciation of assets over time. Due to the current highly volatile nature of the cryptoasset market, participants in such a system won’t have a large inclination to hold onto the tokens they are mining. This phenomenon will lead to increased downward sell pressure on the open market and result in higher token velocity.
While the Proof of Work process has been around the longest and has certainly proven to be a practical, secure method of reaching consensus, new approaches have come to light in recent years.
Proof of Stake (POS)
The Proof of Stake methodology of reaching network consensus was introduced by Sunny King and Scott Nadal back in 2012 in response to growing concerns regarding the high energy consumption associated with mining Bitcoin.
In its current state, the electricity used to mine Bitcoin on a yearly basis is equal to that of some small countries throughout the world. Over 32 houses in the US could be powered for one day with the same amount of electricity consumed in a single BTC transaction.
This phenomenon has grown exponentially since inception of the Bitcoin network and will continue to do so as the network expands and difficulty increases over time unless an alternative is reached
The Proof of Stake process is completely different than that of Proof of Work. The validation process of blocks is not mined with computational power. Instead, the process of determining who receives the rights to claim the block reward is directly correlated to their “stake” in the network.
Just owning a certain percentage of tokens doesn’t give you the right to claim these block rewards, one must actively stake their coins. To combat the notion that there is “nothing at stake” in this model, Vitalik Buterin, founder of Ethereum, has introduced a collateral type system where participants in the network will need to deposit their tokens as their initial stake. This deposit would be locked up for a certain amount of time (via a smart contract) and act as collateral in case of any fraudulent behavior.
If a group tries to validate an invalid transaction, the other nodes/groups on the network will in their best interest not allow this, reaching consensus that this was a malicious and invalid entry. The group who tried to fraud the network will in turn lose their staked tokens (the collateral mentioned above). This method keeps all parties interests aligned in that they will correctly validate all transactions in order to keep their staked tokens safe.
For simplicity sake, let’s assume there are only 100 tokens available in our theoretical token ecosystem, BKC. As founder, I have 30 of these tokens, or 30% of the supply (Group A). The remaining 70% of the token supply is distributed amongst Groups B-H as depicted below.
Using these numbers, Group A (myself) with 30% of all token supply has a 30% chance of successfully validating each group of transactions (a block) broadcasted to the network. Group F with 16% will have a 16% chance, and so on and so forth. In the Proof of Stake model, there are several ways to compensate those who dedicate resources to validating the network: awarding them with the transaction fees within the block(s) they validated, or through interest (inflation) on their tokens that they have staked. If I tried to validate an incorrect transaction and the other nodes agreed on that, I would lose my deposited tokens.
“The one-sentence philosophy of proof of stake is thus not security comes from burning energy, but rather security comes from putting up economic value-at-loss.”
– Vitalik Buterin
The combined result of staking and the deposit required in the Proof of Stake protocol will have a substantial effect on the market dynamics of coins who adopt this methodology. As more and more individuals seek to reap the benefits of staking their tokens – therefore locking them up as collateral – this will greatly decrease token velocity and transition the token into a store of wealth, causing its inherent value to increase over time.
Conclusion
One can argue the benefits and drawbacks of the different processes outlined above until the very last Bitcoin is mined (projected to be sometime around year 2140). What is most important to note is that the community itself can shape and control the direction they wish to pursue. No matter which method they implement, it is crucial to be reminded of the fact that the decentralized and trustless nature of each is what makes this technology so revolutionary and exciting.