Proof of Work & Proof of Stake Explained
There are numerous blockchain consensus algorithms, the most well-known ones being proof of work and proof of stake. But what are consensus mechanisms and what are their strengths and weaknesses?
A blockchain consensus algorithm is a mechanism that enables coordination in a distributed system. It ensures that all parties in a blockchain network can agree on one truth and reach a consensus.
In centralized settings, one single entity has full power over the system and can make decisions and changes on behalf of users. However, in decentralized settings, there is no single entity that can make decisions. Therefore, a solution is necessary to provide trust and agreement in an environment where strangers don’t trust each other — they need to trust the consensus algorithm.
One of the main concepts that blockchain consensus algorithms serve is transparency. These algorithms usually make it costly for network nodes to produce blocks, but cheap for nodes to validate these blocks. Hence, nodes are disincentivized from cheating and incentivized to behave appropriately.
Proof of Work
The most well-known consensus algorithm is proof of work (PoW) and was introduced by Satoshi Nakamoto as the consensus algorithm that would support Bitcoin, even though the concept has existed for a while prior to Bitcoin’s emergence.
The proof of work consensus algorithm works as follows. The miner nodes hash the data in order to produce a specific output solution, which is possible to reproduce if one knows the input, but fundamentally impossible to find the input if one only knows the output. The only way for a malicious miner to re-create the input-output combination is to brute-force inputs, which requires enormous amounts of computing power.
In the case of Bitcoin, miners run the data through the SHA-256 hash function. In order to produce a valid block, miners must combine the block’s transactions along with a variable nonce to produce a hash output that begins with a set number of 0s in order to be valid. The number of 0s required depends on the network’s difficulty, which is adjusted every 2,016 blocks or roughly every two weeks. As of April 2021, Bitcoin’s network difficulty has reached an all-time high of 23.5T (Source: Blockchain.com). This means that in order to successfully mine a block by generating a hash output that satisfies the minimum 0s requirement, massive amounts of computational power is required. This in turn means that miners must invest in specialized mining hardware and bear the cost of electricity needed to power the miner machines.
PoW Miner Incentives
But what is the incentive for miners to bear these costs as well as behave honestly? When successfully mining a block, which then gets validated by the network, miners receive freshly minted cryptocurrency, along with transaction fees.
Users do not need to trust each other. They trust the consensus mechanism.
Therefore this consensus algorithm works in such a way that it is very easy for the blockchain network to verify whether new blocks are valid. On the other hand, it is very difficult for attackers to attack the network, as it requires massive amounts of computing power and electricity. Hence, it is the consensus algorithm that blockchain participants trust and they don’t have to trust each other.
Proof of Stake
Proof of Stake (PoS) was introduced as an alternative to Proof of Work (PoW).
The main difference between Proof of Stake and Proof of Work is that the Proof of Stake consensus algorithm does not require miner nodes, specialized hardware, nor massive energy consumption like Proof of Work does.
So, instead of an external resource like electricity and hardware, what is needed is an internal resource, cryptocurrency. In general, network protocols require a minimum amount of funds to be held, in order for a participant to be considered eligible for staking.
PoS Miner Incentives
While staking, funds are locked up in a wallet and if the user’s block is selected, the user receives a proportion of transaction fees that is proportionate to one’s stake. Therefore, the more funds one has locked up, the higher the rewards.
In contrast to PoW, PoS does not reward with newly minted coins, meaning that the blockchain’s cryptocurrency must be issued in other ways such as with initial distributions (ICOs, IEOs) or by previously operating with PoW before transitioning to PoS.
Trust in Blockchain Consensus Algorithms
So, how does this blockchain consensus algorithm ensure honest behaviour by participants?
Acting honestly is more profitable than acting dishonestly
If one attempts to cheat by proposing transactions that invalid, they will lose a portion or all of their stake. Therefore, acting honestly is more profitable than acting dishonestly.
Even though Proof of Work has been the most widely adopted blockchain consensus algorithms like Bitcoin, Proof of Work has only been applied in smaller cryptocurrencies. Therefore, even though it appears theoretically sound, it is unclear whether it will be able to serve as a viable alternative to Proof of Work. This is because once it’s applied on a larger scale, the system will become a real-life system where game theory and financial incentives come into play. It is expected that PoS will soon be tested on a larger scale with Ethereum 2.0.
Concluding, in order for distributed systems to function it is necessary that mechanisms exist to facilitate consensus within the network. Participants do not trust each other and hence they need to trust the system, in this case, the blockchain consensus algorithms. Of all consensus algorithms, Proof of Work remains the most widely used, while its main alternative that is more energy-efficient, Proof of Stake, is yet to be applied on a large scale. An alternative that is more reliable and more secure is yet to be proposed, and considering the amounts of R&D invested into replacements for PoW, alternative proposals will emerge in the future.
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