Cryptocurrencies don’t need third-party oversight. Here’s how they function without it.
Blockchains are the foundation for cryptocurrencies. They often employ one of two different governing techniques: proof-of-work (PoW) or proof-of-stake (PoS).
But what work is being proved? What’s at stake? And why does it matter? This article will provide the basic concepts you’ll need to understand why these techniques exist, how they work, and what difference it makes to the blockchain and the crypto it supports.
Table of Contents
- Blockchains: Where Crypto Lives
- Proof-of-Work Versus Proof-of-Stake: Validation Versus Consensus
- Miners Get to Prove Their Work
- How Do Proof-of-Work Blockchains Operate?
- How Does Proof-of-Work Ensure Coordination and Security?
- Which Blockchains Use Proof-of-Work?
- What’s Proof-of-Stake?
- Proof-of-Work Versus Proof-of-Stake: The Primary Differences
Blockchains: Where Crypto Lives
Cryptocurrencies have no physical incarnation in the way regular currencies do. While regular or “fiat” currencies can exist in your pocket or bank account, your bank and other regulatory authorities maintain their integrity.
A major difference — and, many would say, advantage — of cryptocurrencies is that they can exist without any supervisory authority.
How do they do that? The simple answer: a type of blockchain technology.
Blockchain is most easily understood if you think of it as a ledger or spreadsheet that can exist virtually and does not have to be centrally managed. No one “owns” a public blockchain in the way a bank would own its ledger .
Blockchain technology enables a ledger of digital transactions to be distributed over a network of computers and participants. It enables permanent, unchangeable recording of those transactions. Even though participants can see transactions, they can’t change them.
Blockchains have various uses. Some help companies use blockchain technology to trace the movement of goods and services across the world, from raw materials to finished products, to distribution and final sales to consumers. But a different kind of blockchain is the home of cryptocurrencies.
Decentralized blockchains allow all participants to have full confidence in the transactions recorded without having to submit to a single regulatory authority. This proves to be a perfect solution for cryptocurrencies, as they operate outside centralized control.
But why the name “blockchain”?
The name aptly describes how it works. Each transaction gets recorded in a “block” that, once validated and verified, is added to a chain of transaction blocks. Once in the chain, they form a permanent, immutable record.
Since the launch of the first widely-used blockchain protocol in 2009, many cryptocurrencies have successfully processed billions of transactions without relying on centralized third-party coordination.
Decentralized networks, including well-known examples, like Zcash, Ethereum, and Bitcoin, rely on rules and mechanisms designed to ensure that every participant or “node” in the network recognizes the same ledger.
These rules and mechanisms differ from the regulatory oversight seen at traditional financial institutions. In the instance of blockchains, they are used to ensure agreement by all users of a blockchain that its records are accurate.
This requires someone to validate transaction records and a mechanism to reach consensus on that validation. This is where proof-of-work and proof-of-stake come into play.
Proof-of-Work Vs. Proof-of-Stake: Validation Vs. Consensus
Consider the necessary two-step process on a decentralized blockchain. First, someone has to validate that a transaction has been recorded properly and “legally”, ensuring that nothing malicious is going on and nothing is accidentally being counted twice.
On many decentralized blockchains, such as the Bitcoin blockchain, any participant running a full node of the network can serve as a validator. This requires lots of computing resources, so there’s got to be an incentive for doing this work. More on that in a bit.
Next, the network has to decide whether or not to accept a new block being proposed by a validator to add to the blockchain. In fact, it often has to decide which block to accept because many validators can be submitting blocks containing the same or related transactions.
In other words, the network has to reach consensus on any block being submitted for addition. The two leading consensus mechanisms today are proof-of-work and proof-of-stake.
Let’s first look at proof-of-work.
Miners Prove Their Work
While cryptocurrencies can use any governing set of rules, Proof-of-work (PoW) is currently the dominant method for coordinating payments or other processes and securing the integrity of common blockchain networks.
“Proof-of-work” is a consensus mechanism that employs a mathematical, cryptographic puzzle to validate each transaction in a blockchain. Due to the complex nature of these puzzles, PoW systems often require the expenditure of lots of processing power before additional transactions are accepted into the network’s global ledger.
The first validator to successfully solve these puzzles receives a reward in crypto tokens. This discourages nefarious or incompetent participants since the price of entry is so high from a computing resource standpoint.
But since there is no guarantee a validator’s block submission will be accepted, especially since there are so many others on the network trying to solve the same problem, getting the crypto reward is a bit like mining: lots of work for the possibility, not certainty, of a reward.
How Do Proof-of-Work Blockchains Operate?
Keep in mind that what follows is not meant to be a fulsome or accurate description of how every PoW system works.
At the backbone of some PoW systems are “miners” racing to validate every incoming transaction.
Under a common model of PoW, every broadcasted transaction in a blockchain first enters a virtual pool with other unconfirmed entries. In this model, miners are free to grab any collection of pending entries to confirm whether each transaction contains a valid signature from the sender along with a sufficient balance.
After confirming a full block of transactions in such a system, miners must then input the entire text of their block along with a randomly generated guess — referred to as “Nonce” for Number Only Used Once — into a cryptographic hash function.
What’s a Hash Function?
A hash function is an algorithmic function that takes an arbitrary amount of data and converts it into a string of text called a “hash.” This protects the original data from being revealed and also stops any future alterations or falsification.
Importantly, the hash function used by blockchain is one-way. That means if you know the hash function and the original set of data, you can always reproduce the same output, but you can’t figure out the original data from the output.
This keeps critical personal data, digital signatures, and the like safe on the blockchain.
Back to the Miners
Before any miner can broadcast their proposed transaction block to the network, the output of their hash function must have a minimum of a certain number of leading zeroes.
For instance, if a protocol required that the output of the hash function must contain four leading zeros in order for its corresponding block of transactions to be considered eligible for addition to the existing blockchain, then any hash function output with four or fewer leading zeros would not satisfy the condition.
An example of a satisfactory output in such a system could be “0000073920484030334.” Bitcoin’s SHA-256 (a type of hash function) is capable of producing 1.1 *1077 possible outcomes — a number that dwarfs all the grains of sand on Earth.
While a single computer could spend thousands of years re-adjusting the Nonce to crack this code, a network of many computers is capable of consistently solving this puzzle on the Bitcoin protocol about every ten minutes.
After hitting the target and the successful miner broadcasts its block, every node in the network must verify that the corresponding transactions align with consensus rules and that the miner correctly solved the cryptographic puzzle.
If either condition is not met, the network is free to ignore the proposal. If the network accepts the block, the miner is rewarded by “mining” new coins or simply writing an entry in the public ledger paying themselves according to the protocol rules.
If two miners broadcast proposals at the same time or provide conflicting information, the network is often designed to wait and see onto which prior proposed block the next block is added. In many blockchain protocols, the network only recognizes the longest known chain, and in PoW, the longest chain represents the largest energy expenditure.
How Does Proof-of-Work Ensure Coordination and Security?
Many proponents of PoW protocols state that they are difficult, costly, and time-consuming by design. These characteristics are designed to make network attacks more costly, thus improving the security of the network.
Cryptographic functions used in PoW systems are designed to be challenging to solve and easy to verify. Anyone looking to add entries to PoW blockchains must contend with the time, energy, and resources needed to compete in creating the next block, with no guarantee of producing that block.
These features of many PoW systems are designed, to some extent, to reduce the likelihood of attacks on the network by forcing any actor trying to corrupt the blockchain to obtain sufficient resources to outperform all other actors on the network combined.
Which Blockchains Use Proof-of-Work?
Proof-of-work is widely held to have been popularized by Satoshi Nakamoto, the pseudonymous identity of the creator of Bitcoin. Since the launch of Bitcoin, many other cryptocurrencies have employed their own version of PoW.
Some PoW protocols operate on the same SHA256 algorithm employed by Bitcoin, but others have embraced their own cryptographic puzzle to alter the details of their protocols, like the time and energy expenditure needed to mine a new transaction block.
As the crypto market continues to experiment and innovate, alternatives to proof-of-work have emerged.
A huge motivation for these alternatives is climate change. As we’ve seen, proof-of-work intentionally uses difficult math problems that require a ton of computing resources to solve. Computing resources require energy, and lots of energy means a large carbon footprint.
Proof-of-stake (PoS) — a model first employed in a cryptocurrency by Peercoin to reduce time and energy expenditures — has become a well-known, energy-saving alternative to PoW.
Instead of having validators (miners) compete to solve a puzzle that requires them to invest in expensive computing equipment, the validators put up crypto coins to qualify to be a validator on the network.
In this case, the price of entry (the staked coins) is high enough to weed out bad actors. Validators are chosen at random from a pool of participants who have staked sufficient coin. Some approaches even skew future assignments to those with higher stakes in the blockchain.
Individual blocks are validated by more than one validator to keep things level. When a sufficient number of validators agree, the block is accepted and added to the chain.
The proof-of-stake has raised some questions about security. In theory, a participant or group that controlled 51% or more of the staked crypto could use its majority to alter the blockchain in malicious ways. In practice, though, this is highly unlikely to happen.
The staked crypto functions as collateral. If you default on a loan you’ve put up collateral for, you forfeit the collateral. A similar principle applies to proof-of-stake.
If a group with a controlling amount of staked crypto attempted to alter a block, they would risk losing all of the crypto they had staked — a strong deterrent. Having that collateral keeps everyone honest.
Other measures, like proof of space, are similar to proof-of-work but require computer storage rather than computation to secure the network.
Proof-of-Work Vs. Proof-of-Stake: The Primary Differences
Both proof-of-work and proof-of-stake serve as consensus mechanisms on a decentralized blockchain. But they accomplish the objective in very different ways.
As we’ve mentioned, PoW relies on participants with plenty of computing power and the appetite for competition to solve tough math puzzles. PoS skips the competition and allows anyone willing to put up the crypto coin as collateral to play.
In proof-of-work, validators are called “miners” because they get crypto rewards for their validation work. In proof-of-stake, the validators collect network fees as a reward. And on many PoS blockchains, the higher the stake, the more likely a validator is to get work.
Proof-of-stake tends to scale very well, allowing the blockchain network to grow, a consequence of their energy efficiency. Proof-of-work is not so inherently scalable.
Finally, the carbon footprint of PoW is large and may be an albatross around its neck in the long term. As the world looks for any and all ways to reduce atmospheric carbon, any cryptocurrency running on a PoW blockchain will be at a real disadvantage.
Why Should You Care?
In the end, does it matter whether a crypto’s blockchain uses proof-of-work vs. proof-of-stake?
You should always try to fully understand the asset you are buying or looking to trade. Cryptocurrencies are no exception. Knowing how and when they originated, what their price history has been, and what kind of community or ecosystem supports them all matter.
But knowing a bit about the crypto’s foundation — the blockchain it runs on — is important, too. Consensus mechanisms are a critical part of a blockchain’s operation, so it pays to understand what’s going on and how that might affect your crypto.
It also pays to have a solid crypto partner by choosing the right crypto platform. At Binance.US, we don't just make it easy to buy and sell. We also offer a wide range of crypto and tons of insight and education on them and how they work.
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