Proof of Work & Stake consensus mechanisms and its implications to everyone involved

A refresher for those already familiar and a starter guide for beginners on what they are & the tradeoffs from my perspective. Environmental impacts and Money vs Equity implications.

Abstract

By now, many of us have heard about the terms Proof-of-Work (PoW) and Proof-of-Stake (PoS) when we first started dabbling into crypto-assets. This article aims to address what these consensus mechanisms in the blockchain mean and why is it a complicated debate on which one is better & what this means for us as speculators or developers.

How it started

The PoW concept was invented in 1993 and the term was first coined and formalized in a 1999 paper by Markus Jakobsson and Ari Juels. In 2008, Satoshi Nakamoto (the alias of the anonymous inventor of Bitcoin) discovered that this PoW system was perfect for a digital transaction system that could be operated without a central authority, released in the Bitcoin Whitepaper.

Shortly after he created the first block and it went live, it created shockwaves in the world , spreading like wildfire and disrupting many things it touched. Nobody knew what it was, how to value it or control it. On top of the attacks on it being known to transact for illegal activities on the dark web, critics came after its energy usage. That’s right, Bitcoin’s PoW consensus system requires energy (or work) to function. Bitcoin uses more energy than countries such as Norway, Sweden, Ukraine, Argentina or Philippines.

Where its going

Now, if you just heard of these comparisons, you are likely shocked. This is where PoS comes in. Thousands of crypto projects in recent times utilize the PoS model, all claiming to be more efficient than the PoW model. There is a big problem here though. Are these claims even true? Or are they marketing false promises? With the current context of crypto on social media and VCs rushing to find the next best investment, its hard for people to discuss the risks in an open, honest and intellectual way. Often, PoS is discussed with its benefits and ignores the tradeoffs with PoW.

Now, lets dive in:

Proof-of-Work Explained

The Bitcoin network is programmed to make a block every 10 minutes and add it to the blockchain. Miners help to produce new blocks by consuming processing power to solve a cryptographic puzzle that the previous block created. They are incentivized to do this at the expense of the capital needed as they can be rewarded in BTC through block rewards and transaction fees. At this point, the miners can package thousands of transactions into that block, which is how transactions get settled on the ‘ledger’.

There is something known as the difficulty adjustment which happens every 2 weeks. In simple terms, the bitcoin algorithm automatically changes how difficult it is to mine a block based on the hash (or processing power) rate. As more miners are connected to the network, its get increasingly difficult. This is done to ensure the supply of BTC remains limited over a long period of time.

Just like gold mining, BTC miners put forward work/energy to mine bitcoin. Just like how people value gold due to its rarity, people value bitcoin because its scarce and difficult to find. Millions of machines use electricity to apply processing power to guess the answer to a puzzle; Proof-of-WORK as the name suggests.

It is simple, there is no need to punish bad miners that try to validate the wrong blocks that don’t fit into the criteria of the node network. The punishment is that they spend electricity on validating wrong blocks, sort of a self-inflictment, so it rarely happens.

Benefits (and Cons) of PoW

This seems like a waste of energy, but this is what keeps the system secure and decentralized, no central authority determines a valid set of transactions. The largest bitcoin miner in the world only has around 1% of the total hash-rate, in that sense, it is quite decentralized.

Bitcoin’s PoW makes it bullet proof to 51% attacks, where a single entity temporarily or permanently gains control over 51% of the processing power, and uses it to reorganize blocks and perform double spending transactions (*COUGH* forks of BTC such as Bitcoin Cash and Bitcoin SV).

For someone to attack the network, he would need to purchase up insane amounts of hardware and electricity costs to overrule the blockchain. Even then, the algorithm will automatically fork using the last longest chain, making all the efforts attacking to be to no avail.

Energy and environmental discussion

We are not going to sit here and pretend that the energy consumption bitcoin uses is not enormous and worrying. Bitcoin, in its nature is known to consume a lot of energy. In the aforementioned sections, we can see how mining itself consumes more power than several countries combined. And yes, this is worrying and it needs to be addressed.

Luckily for us, the people and companies in this space are pushing forward creative ways to significantly reduce energy consumption and also push for for the transition to renewable energy, in which the world needs gravely, regardless of bitcoin.

There has already been moves made where there’s increasing integration between miners and energy producers, seeing signs of this through co-location where an energy producer (solar, hydro, etc.) has bitcoin miners operating on their sites through contracts. The electrical grid naturally has to over-produce electricity, otherwise, if we did not have extra productive capacity, turning on a laptop would cause a brownout.

So we have this spare production always going into the network grid, and we have to find ways to drain out excess power that is being produced but not consumed, like a tricky balancing act. PoW actually acts as a good load balancer. However, this area of collaboration isn’t fully mature yet and Bitcoin mining on the environment still poses a huge threat if we cannot find and implement ways to improve the situation across the majority of mining conducted.

Proof-of-Stake Explained

Simply put, it is a system where crypto holders stake their coins, use them to vote on the valid blockchains and get rewarded with more coins for successfully creating new blocks. So instead of using processing power or electricity, they put forth their stake of coins. In terms of punishing bad actors, PoS is more complex than PoW since there is no connection with real world resources like energy. Stakers can technically attack the blockchain without punishment. But in the PoS systems we have today in popular cryptocurrencies like Ethereum, it works around the problem by slashing (taking away) stakers’ coins if they vote improperly. Although PoS doesn’t have big issues of the impact on the environment like BTC’s PoW, this solution comes with a few trade-offs, one being complexity.

PoS Complexity (for developers)

The current issue with Ethereum is that more and more changes and updates are applied over time, adding complexity to the code. We are already past the point where anyone has a full picture of how the system works. If a protocol gets more complex or less slim, less and less developers will be able to grasp its complexity, putting the system at risk.

The reason the shift to Eth2.0, its PoS system is taking so long is because they have relied on PoW for over 6 years now and that PoS is indeed complicated. PoW is fundamentally simple, easy to analyze, implement and deploy. PoS has a lot of moving parts.

You can code up a PoW algorithm in 10 lines while you could take around up to around 100,000 lines in PoS algorithms. The PoW consensus has served ETH well and they want to ensure that enough research and bulletproofing is done before they roll out ETH2.0 (speculated end of 2022 or start of 2023).

Centralization (risk of PoS)

The more coins you have, the more voting power you have. Those with the coins are also the ones earning new coins from staking. Since they don’t need to spend resources to stake, they can increase the overall staking amount by earning ongoing coins from staking rewards; A political system where the more money you have, the more power you have. This defeats the purpose of a decentralized blockchain (a tiny fraction of multi-billionaires would have voting and earning rights)

Instead, the PoS system works well in stakes of centralized private property like corporations. In a corporation, each share is worth a vote for proposals and board seats since the owners decide what the company will do in proportion to their ownership.

Centralization counter arguments with PoS

In a sense, PoS consensus also make it hard for people to own a majority of the share since the barriers to entry are low in crypto, by anyone from anywhere. With competition around in the space, this allows the bad traits of PoS’s centralization to be filtered out to newer protocols or companies that align with decentralization; People can always go elsewhere in this ever-evolving space.

What makes good money?

The creator of PoW, Adam Back, describes why PoW outperforms PoS when it becomes a money-like asset. “PoW is a system that works because money has a cost, money that doesn’t have a cost ultimately becomes political in nature, such that people close to the money are advantaged”. People with large amounts of a token running on a PoS network can influence voting decisions and rake in even more profit, easily increasing his supply with ease. PoS represents a stock like asset rather than monetary assets.

Healthy Competition

Like the US having 3 branches of power (executive, legislative and judicial which are allowed to overule each other in some contexts - not being able to keep people in power for too long, instead being able to vote them out for more capable individuals), BTC also has 3 branches: Node network, Miners and Developers.

This allows for healthy competition between each branch. For example, for the node network and miners, there is competition between the hardware and network bandwidth they have. For the developers, there is competition in which developers comes out with the best algorithm to process these updates in the system in which people can vote for.

However, in many PoS systems, they make multiple tradeoffs, including making the nodes require immense processing power, bandwidth and storage , such that only large entities can run them, which centralizes the network into major providers. Increasing the complexity of a base layer of a blockchain also makes it harder for an individual to run a full node, and without full nodes, it relies more on trust and much less on decentralization.

What if BTC was built on PoS?

If Bitcoin was built on a system where the more coins you have, the more votes you have on how the network functions, the large exchanges and custodians who have millions/billions of coins they held on clients behalf have the ability to vote in their own favor. This is similar to how Blackrock maintains the voting rights to trillions of dollars of client assets. PoW and a network full of small nodes is the only way (for now) to keep a blockchain sufficiently decentralized and secure on the base layer. If Bitcoin were to transition to a different system, it would only be possible with the overwhelming consensus among its users.

Some TL:DR diagrams for comparisons (credits to Blockworks.co)

Fundamentals of PoW and PoS

Comparisons of PoW and PoS (Pros and Cons)

Conclusion/Summary; TLDR

Both PoW and PoS are extremely powerful in their own way. There are some significant tradeoffs summarized in the diagram above. In short, PoW requires energy to validate blocks to ensure transactions are all sound and secure while PoS wants to do the same but without using real energy, but using a system of staking delegations to control decisions made in validating the network. PoS’s main benefit is allowing the blockchain to scale up with the amount of users and potentially keeping transaction fees low.

In my opinion, PoS has a lot of potential moving forward and I believe ETH2.0 can succeed. However, they need to iron out the issues it faces with complexity and security.

Thank you for reading! Do share with your loved ones.