The creation of cryptocurrencies all involves a consensus mechanism to validate or prove transactions in the blockchain. Numerous consensus mechanisms exist, though currently, the two prime ones are proof-of-work and proof-of-stake. In this article, we’ll briefly cover both of these in detail, observing their advantages and disadvantages and whether one is substantially better than another.
The basics of proof-of-work
To understand the principles of a consensus mechanism, we should appreciate that one of the core features of cryptocurrencies is decentralization. More specifically, not having a central authority means there’s no third party that can validate transactions, as is the case in the traditional financial system. Bitcoin was the first example that utilized this model to validate transactions without any governing authority.
In the blockchain, each block needs solving using cryptography, essentially an advanced form of mathematics. This function is the only method for validating transactions for each block. Since the mathematics involved is far too complex, advanced computers (mainly in the form of CPUs, GPUs, and ASICs) are required to solve the equations.
The whole process is known as mining, and miners from around the world compete for solving the algorithms. Whichever miner is first to decipher the equation for each block is rewarded some portion of the currency depending on how much power they’ve contributed computationally.
Examples of cryptocurrencies that use the proof-of-work model, aside from Bitcoin, include Ethereum, Litecoin, Monero, and Zcash, among countless others.
The pros and cons of proof-of-work
This procedure enables the native users to make decisions based on how they’ve contributed to mining power, which is the whole point of a consensus mechanism.
However, proof-of-work presents three serious problems:
- Limited number of transactions that can be processed.
- Significant electricity costs and expensive equipment.
- PoW is inherently an unfair system as it favors miners with cheap power and advanced computers.
When analysts make arguments on the disadvantages of proof-of-work, they often refer to Bitcoin because it was the currency that pioneered the concept. Roughly every ten minutes, 1 BTC block is formed, with the network handling about seven transactions per second. Compared to other cryptocurrencies, these times are too slow for a currency meant for seamless everyday use by the general public.
As a result, Bitcoin’s transaction fees can be in a state of flux when they become too high even for small amounts. While there are countless other coins using proof-of-work and are technically faster than Bitcoin, they also experience similar issues.
Proof-of-work consumes large quantities of electricity for miners. This disadvantage is easily understandable because using a lot of electricity can become costly, especially for miners who live in countries where power is not inherently cheap. Environmentalists also consider high electricity consumption as environmentally unfriendly.
Lastly, the rationale for why proof-of-work is largely unfair relies on the premise that only the most expensive and powerful equipment stands the better chance of receiving rewards. Some have argued over China’s dominating mining power in cryptocurrencies like Bitcoin where they not only produce and use powerful machines, but live in places with cheap electricity.
The basics of proof-of-stake
Proof-of-stake rewards participants, not for mining to solve the equations, but rather on how much they’ve ‘staked’ (hence the term, ‘proof-of-stake’). A stake is merely the number of coins native to the blockchain a participant has locked in a crypto wallet. There is a minimum required stake, which differs with every cryptocurrency.
In proof-of-work, participants are primarily known as miners, while in proof-of-stake, they are known as forgers since they aren’t technically mining. In POS (proof-of-stake), forgers earn transaction fees. In POW (proof-of-work), miners earn block rewards.
For POW, whoever contributes the most computational power stands the best chance to receive a reward. In POS, whoever has the largest stake stands the greatest chance to earn transaction fees. Both these processes are random as the blockchain algorithms will select either who has the most powerful computer or who has the biggest stake, respectively.
Examples of cryptocurrencies that use the proof-of-work model include Binance Coin, Polkadot, Cardano, Stellar, and Neo, among many others.
Pros and cons of proof-of-stake
The POS design consumes tremendously less electricity than POW. As a result, you don’t need to own expensive equipment. Becoming a forger is a less physical process because it only requires purchasing the cryptocurrency that you’d want to stake. Coins using this design are more scalable because transactions can be confirmed quicker.
Analysts point out three disadvantages with proof-of-stake:
- Proof-of-stake can discriminate against less wealthy individuals since the more one can stake, the higher likelihood they can earn. Some cryptocurrencies require large stakes to be eligible for participation. However, we can translate the same argument to proof-of-work, where only the wealthier that can afford hefty equipment stand greater chances to earn rewards.
- Unlike the proof-of-work structure that works on one chain, POS allows people to verify transactions on multiple chains. Miners fear this duality can increase the possibilities for what is known as double-spending.
- Although this could also be a positive, staking also encourages saving instead of spending coins.
Proof-of-work or proof-of-stake, which is better?
There are essentially three main reasons why some people believe proof-of-stake to be a better model than proof-of-work boils down to the significant electricity cost reduction the former brings. The second reason for the belief in POS is if any participant acted maliciously, they would stand to lose their stake. There’s a more significant negative consequence for bad actors in proof-of-stake than proof-of-work. Lastly, coins using POS are more scalable compared to POW, where validating transactions can be cumbersome.
These explanations are perhaps the only real distinctions. Unfortunately, the common thread is that both versions do still discriminate to some extent on privilege. Therefore, no approach solves the fairness problem conclusively.
In POW, to increase your odds of success, you need to invest in costly equipment and have cheap power. In POS, you need to have a large stack of coins, which also costs a lot of money.
Another aspect that comes into the conversation is the possibility of a 51% attack. A 51% attack (which happens very rarely) is when a group of miners control more than 50% of a cryptocurrency’s computational power.
In both models, theoretically, 51% of attacks are possible but extremely unlikely. Nonetheless, one prominent coin that enthusiasts believe will eventually switch towards proof-of-stake is Ethereum.
However, no date has yet to be confirmed, and there’s no guarantee the switch will happen. If Ethereum did eventually switch, we could see more noticeable cryptocurrencies, perhaps doing the same.
The methods in which the blockchain proves transactions in cryptocurrencies make for interesting observations. Only time will tell whether more coins will adopt proof-of-stake or that there will be an equal use of both approaches.