Though Bitcoin's (BTC) transaction history is securely sequenced using proof-of-work (PoW), it consumes a lot of electricity and the number of transactions it can handle at once is limited. As a result, new consensus mechanisms focusing on the less energy-intensive method have emerged, with the proof-of-stake (PoS) model being one of the most prominent. These consensus mechanisms enable computer networks to collaborate while remaining secure.
Blockchain networks need to resolve several issues in order to function effectively. For instance, without a central authority like banks or FinTechs (e.g.PayPal) in the middle, decentralized cryptocurrency networks must ensure that no party in a network spends the same money multiple times. Furthermore, the consensus mechanism prevents the network from being derailed through a hard fork.
However, in a centralized organization like a bank, the board of decision-makers or regulators control such activities. Whereas crypto is based on a community, so the blockchain must reach a consensus to verify the transactions and blocks.
Proof-of-work and proof-of-stake are the two main consensus mechanisms presently used by decentralized finance (DeFi) projects to cryptographically obtain consensus on cryptocurrency networks. When Satoshi Nakamoto was creating Bitcoin (the first cryptocurrency), they needed to figure out a means to verify transactions without the involvement of a third party. To achieve this, they employed a consensus mechanism called proof-of-work to allow networks to agree on which transactions are valid.
On the contrary, proof-of-stake (PoS) is a modern consensus method that powers newer DeFi projects and cryptocurrencies. Some projects begin with PoS right away or are transitioning to PoS from PoW. However, building a PoS consensus network right away is a significant technological issue, and it is not as simple as using PoW to gain network consensus.
What is proof-of-work?
Proof-of-work was first proposed in 1993 to fight against spam emails on a network and denial-of-service attacks. The PoW concept was then popularized by Satoshi Nakamoto to validate new blocks in the Bitcoin network in 2008.
PoW is based on network users' capacity to prove that a computational task is accomplished. To answer a mathematical equation, some computing power known as a node is employed, and once the equation is solved, a new block on the chain is validated. A node is any physical device like a personal computer that can receive, send, or forward data within a network of other tools.
The solver that answers a mathematics puzzle the fastest, will create a cryptographic link between the current and previous blocks and earn some freshly minted crypto coin. This process is known as mining, and the solvers are known as miners. It is through their combined efforts that a blockchain is kept secure for all parties involved. Moreover, the computational task of solving this puzzle itself is called proof-of-work.
How does PoW work?
A blockchain is a system that consists of a series of blocks arranged in chronological order based on a transaction order called blockchain ordering. The genesis block, or block zero, is the first block in a PoW blockchain, which is hardcoded into the software. This block does not, by definition, refer to a previous block. The subsequent blocks uploaded to the blockchain always refer back to the prior blocks and contain a complete and updated ledger copy.
Through a competitive race in which some participants or miners are encouraged to expend computational resources to submit legitimate blocks that fit the network's regulations, PoW algorithms select who gets to amend the ledger with the new entries. The ledger keeps track of all transactions and organizes them into successive blocks so that no user can spend their funds twice. To avoid tampering, the ledger is distributed, allowing other users to reject an altered version rapidly.
In practice, users identify tampering using hashes, which are long strings of numbers that act as proof-of-work. The hash function is a one-way function, which means it can only be used to check that the data that generated the hash matches the original data.
After that, nodes verify transactions, prevent double-spending and decide whether or not the proposed blocks should be added to the chain. The act of making payments twice with the same currency to deceive the recipient of those funds is known as double-spending. Double-spending would wreak havoc on the network and eliminate one of its most valuable features: immutability, decentralization and trustlessness.
Proof-of-work makes double-spending incredibly difficult because changing any part of the blockchain would involve re-mining all subsequent blocks. Because the machinery and power necessary to execute the hash functions are expensive, it makes it impossible for users to monopolize the network's processing capacity.
Furthermore, to generate consensus and secure the legitimacy of transactions recorded in the blockchain, a PoW protocol combines computational power with cryptography.
Miners compete to develop the correct answer to the mathematical problems during the hashing process to produce new blocks. Miners achieve this by guessing a hash, which is a string of pseudorandom numbers. A cryptographic hash (e.g., SHA-256) is a type of text or data file's signature. For a text, SHA-256 provides a nearly-unique 256-bit (32-byte) signature.
When coupled with the data in the block and processed through a hash function, the hash must generate a result that fulfills the protocol's stated requirements.
The miners who won the hash then broadcast it to the network, allowing other miners to check whether the answer is correct. If the answer is accurate, the block is added to the blockchain and the miner receives the block reward. For instance, the current block reward for Bitcoin mining is 6.25 Bitcoin.
Pros and cons of PoW
Pros of PoW
In PoW, miners must pay a lot of money for electricity to solve complex mathematical puzzles and process a block on the network. The electricity is used to power the machines that generate digital assets through the process of verifying transactions, called mining. Moreover, energy expenditure is critical to the network's security, as it allows it to keep an accurate record of transactions and adhere to a specified, credible monetary policy.
Furthermore, the network is kept secure because defrauding the chain would require a malicious actor to take over 51% of the network's computing power. If a blockchain gets forked in a proof-of-work system, miners must choose whether to move to the newer forked blockchain network or continue supporting the original blockchain.
A miner would have to split their computational resources between the two sides of the fork in order to support both blockchains. As a result, through an economic incentive, proof-of-work systems naturally prevent constant forking and urges the miners to pick the side that does not wish to harm the network.
These characteristics lend themselves to the game theory, in which miners must act strategically to optimize their investment returns. People, like bounded rationality states, will always choose the simplest solution. Moving to a newer chain makes things more difficult. Therefore, game theory helps oligopolies avoid internal corruption and make logical decisions.
Cons of PoW
Despite the above advantages, PoW could be quite costly and inefficient in terms of resource usage. Miners must cope with a variety of expenses, including the latest equipment that quickly wears out. Mining tends to produce a lot of heat and could rack up exorbitant electricity, depending on the location of the miner. Furthermore, the system's transaction fees soar when the network becomes overloaded.
Additionally, if you are vulnerable to a 51% attack or if you're not on the most significant coin holder for any interchangeable hashing algorithm, individuals on a larger coin might turn their hardware against you and take you out, and you can no longer earn an incentive.
What is proof-of-stake?
In 2011, a new approach was proposed on the Bitcointalk forum to address the inefficiencies of the PoW consensus mechanism and lower the amount of computational resources required to run the blockchain network. Instead of performing tangible work, this concept is based on the existence of a verifiable stake in the ecosystem.
To put it another way, to validate transactions on the crypto network, a user only needs to show that they own a particular quantity of cryptocurrency tokens that are native to the blockchain. This type of consensus mechanism used by blockchain networks to achieve distributed consensus is called the proof-of-stake consensus mechanism.
For instance, miner A stakes 30 coins, miner B stakes 50 coins, miner C stakes 75 coins, and miner D stakes 15 coins. Miner C would be given priority to write and validate the following block in this case. In contrast to the block reward in proof-of-work, Miner C will collect transaction fees, i.e., network fees.
How does PoS work?
The genesis block is the initial block in a PoS blockchain that is also hardcoded into the program. The subsequent blocks uploaded to the blockchain always refer back to the prior blocks and contain a complete and updated ledger copy.
In the PoS network, miners do not compete for the right to add blocks. Rather than being mined, the blocks are frequently referred to as “minted” or “forged.”
PoS blockchains, unlike PoW blockchains, do not limit who can propose blocks based on energy usage. Despite the high energy requirements of PoW blockchains, novel consensus mechanisms like proof-of-stake eliminate the need for mining.
The proof-of-stake system has several advantages over the proof-of-work scheme, including greater energy efficiency as mining blocks don't use much energy. Additionally, you don't need top-of-the-line technology to create new blocks. Proof-of-stake results in the network having more nodes.
More nodes in a network help develop governance norms that provide a stronger immunity to centralization. In PoS systems, this is made possible by a higher degree of hardware independence. As a result, proof-of-stake is frequently seen as the consensus algorithm least likely to lead to network centralization.
Users who want to be considered for inclusion in the process of adding blocks to a PoS blockchain must stake, or lock, a specific amount of the network's cryptocurrency in a unique contract. Their odds of being chosen as the next block producer are determined by the quantity of crypto assets they have staked. If users act maliciously, they may lose their stake as a result of their actions.
PoS may include other determining elements that do not always benefit the wealthiest nodes, including the length of time a node has staked its money, as well as pure randomization. The block reward in PoS refers to a network fee granted by the blockchain to the person who submits a valid block, similar to the PoW mechanism.
In PoS, block selection is based on coin ownership; therefore, staking services are offered by the exchanges, which allow users to stake crypto on their behalf in exchange for more consistent rewards. Multiple stakeholders can join a staking pool to pool their computing resources and maximize their chances of being rewarded. To put it another way, they pool their staking power during the verification and validation of new blocks to maximize their chances of receiving block rewards.
Pros and cons of PoS
Pros of PoS
The issue of high amounts of wastage of energy resources has been addressed in PoS. Furthermore, PoS-based systems are far more scalable than PoW-based systems, and transactions are approved much faster. Scalability means that the system achieves higher transactions per second (TPS) than specific, current systems by changing the system’s parameter or altering its consensus mechanism.
PoS network achieves scalability by establishing a consensus before blocks are constructed, which allows for the processing of thousands of requests per second with less than a millisecond latency spike.
Cons of PoS
Proof-of-stake, on the other hand, has its own set of difficulties. The network, for example, is still subject to dominance by the most significant token holders. This provides more power to early adopters and people with the most money.
As the concept is still relatively new, it may have drawbacks that are not yet evident to the crypto community. This paradigm, unlike proof-of-work, does not have a track record of performance. Furthermore, forking is not automatically discouraged by proof-of-take systems. A validator will receive their stake's duplicate copy on the newly forked blockchain when a blockchain splits
The “nothing at stake” dilemma occurs when a validator signs off on both sides of a fork, allowing them to potentially double-spend their coins and collect double the number of transaction fees as a return.
Proof-of-work vs. proof-of-stake
It is evident from the preceding explanations that both consensus mechanisms have advantages and disadvantages. They all have the same essential aim as the ones listed above, but they use different methods to achieve it.
The critical distinction between various consensus mechanisms is how they delegate and reward transaction verification. Other differences are explained in the table below.
When should PoW or PoS be used?
The consensus mechanism is crucial to the distributed design of a blockchain network because it reduces the centralization of the entities in charge of validating transactions. To keep a blockchain network's immutable, trustless and distributed characteristics requires a fully functioning consensus mechanism.
The type of consensus required depends upon the needs of a network. For instance, proof-of-work is required for fraud prevention, security and trust-building in a network. Miners (or independent data processors) cannot be misled about a transaction because of the protection provided by PoW. Proof-of-work is a method of securing a crypto asset's transaction history while also increasing the difficulty of changing data over time.
The requirement of a participating node demonstrating that the work is completed and submitted qualifies it to add new transactions to the blockchain, protecting any malicious activity.
If there are numerous copies of the blockchain on the network, PoW helps identify the most legitimate copy. Finally, proof-of-work is essential for building a distributed clock that allows miners to freely enter and exit the network while maintaining a consistent operation rate.
Similarly, network performance and security are significant consequences of using a PoS-based mechanism. PoS is utilized when high transaction speed is required for on-chain transactions per second and actual network transfer settlement. Moreover, validators are likely to own significant amounts of the network token, which financially incentivizes them to keep the chain secure.
However, there are some doubts about the strength of PoS and PoW security against threats. Therefore, a validation mechanism called proof-of-space, or the (Chia project) is created to validate transactions safely. Chia uses a proof-of-space and proof-of-time consensus mechanism to resolve some of the centralization issues that plague PoW and PoS blockchains.