This article aims to provide an overview of two consensus mechanisms that power blockchains. It references Bitcoin and Ethereum. If you are unfamiliar with DeFi, you can read our articles on DeFi, blockchain, and cryptocurrency before reading this article.
The world of blockchain, crypto, and distributed ledger technologies operates on a model of decentralization without any central governing body. This begs the questions: How are transactions securely verified on the public ledger? How are issues associated with digital cash systems, such as the double spending problem, prevented?
In the absence of centralized authorities, consensus mechanisms such as Proof-of-Work (PoW) and Proof-of-Stake (PoS) are integral to blockchains. As the first cryptocurrency, Bitcoin (BTC) popularized the PoW mechanism. PoW is used by chains such as pre-merge Ethereum (ETH), Litecoin, and Monero. PoS, on the other hand, is a mechanism used by emerging blockchains such as Avalanche, Polkadot, Cardano, and Ethereum 2.0.
What Are Consensus Mechanisms?
Consensus mechanisms or consensus algorithms are computing processes that allow a network of nodes to verify and record blocks of transactions in a permissionless and distributed setting without central leadership. Apart from PoW and PoS, there are also other types of consensus mechanisms such as Proof-of-Authority (PoA), where validators “stake their reputation” and Proof-of-History (PoH), a newer mechanism used by Solana.
What Is Proof-of-Work?
A Brief History
Proof-of-Work is a cryptographic concept introduced in 1993 by Cynthia Dwork and Moni Naor to prevent attacks such as email spam. In 2004, computer scientist Hal Finney adapted this idea to “reusable proof-of-work” with the use of token money in transactions. This concept was made popular in 2009 when Bitcoin went live and achieved distributed consensus.
How Does PoW Work?
In PoW, nodes or miners expend substantial amounts of computational power to compete in solving a complex mathematical problem by coming up with the correct hash. The miner who solves the problem gets to add the block to the chain, and is compensated in the network’s coin, such as BTC or ETH. Miners, therefore, employ robust computerized hardware to solve these equations. Since many resources are needed, bad actors are disincentivized from overtaking the network.
Advantages of Proof-of-Work
Prevents 51% Attack
The main praise for PoW is that the blockchain is abundantly secure in a decentralized manner. The PoW consensus mechanism helps to prevent a 51% attack because attackers would need to control more than 50% of the network’s hashing power to disrupt the network. It would require nearly US$8.1B in equipment and other resources to execute a successful attack on the Bitcoin network. This exorbitant amount helps to prevent malicious activity.
Drawbacks of Proof-of-Work
As the first popularized consensus mechanism, PoW has been lauded for its high-security features, but it is heavily criticized for heavy energy wastage and risks of centralization.
High Energy Consumption
PoW’s heavy energy wastage and large carbon footprint remain the top of the environmental concerns associated with blockchain technology. About 150 terawatt-hours of electricity is consumed annually to secure Bitcoin alone. Reports conclude that in 2021, Bitcoin used 0.5% of the world’s energy consumption, more power than the entirety of Finland, while pre-merge Ethereum surpassed the energy usage of Belgium. This raises urgent concerns regarding the growth and mass adoption of the network.
Risk of Centralization
PoW also comes with a centralization risk. Due to its immense computational and energy demands, a small number of mining pools have aggregated a significant level of hashing power. This increases the risk of a 51% attack that decentralization of the network is meant to prevent in the first place. Four mining pools – Foundry USA, AntPool, F2Pool, and Binance Pool – pose a threat of controlling the network for self-serving reasons.
What Is Proof-of-Stake?
A Brief History
PoS is a consensus mechanism first implemented for Peercoin (PPC) in 2013. Sunny King and Scott Nadal drew up the theoretical framework to solve Bitcoin’s high energy consumption PoW algorithm. PoS is a widely adopted alternative to PoW, used by networks such as BNB Chain, Cardano, and Solana.
How Does PoS Work?
In PoS, instead of expending computational power to solve a mathematical problem, a pool of validators stake crypto for a chance to validate transactions. The specific mechanism varies between chains, but generally, validators are chosen based on the amount of crypto staked or how long it has been staked for. The network of validators will attest to valid transactions to be added to the next block. Validators receive a portion of the transaction fees as a reward, depending on the amount staked. Similar to PoW, validators are incentivized to act with integrity and in the network’s best interest. Conversely, they lose their staked crypto if they behave dishonestly.
Advantages of Proof-of-Stake
PoS is more energy-efficient compared to PoW because, unlike mining, not much energy needs to be expended for staking.
For PoS, the barriers to entry to become a validator is lower. Compared to PoW, there is a shift from the computational costs of solving cryptographic problems with physical hardware to the economic costs of staking coins. It is thus more accessible, dramatically increasing the network’s capacity. The network will then be able to support higher transactional throughput to become more scalable.
PoS has a lower risk of centralization. With increased accessibility and lower barriers to entry, there can be more validators compared to the monopoly of a few pools in the PoW system. Hence, this lowers the chance of an individual node owning more than half of the market capitalization, which could lead to a 51% attack.
Drawbacks of Proof-of-Stake
Decentralization Dependent on Market Cap
If PoS is used for networks with a lower market cap, the chances of an attack would increase since there is a higher probability that attackers can accumulate enough coins to gain an advantage over other validators. For instance, a whale that owns a huge portion of the market cap in a cryptocurrency will be able to dominate governance votes.
The Rich Get Richer
PoS is also criticized for encouraging monopolization and plutocracy since the more crypto that is owned and staked, the higher the probability of becoming a validator. The validator is then rewarded with a portion of transaction fees, gaining even more crypto. Not only does this feed the notion of “the rich get richer”, it also increases the power of these validators over the network since voting rights are proportional to the size of their stake, negating the goal of decentralization.
A Comparison Between Proof-of-Stake and Proof-of-Work
What Can We Expect in the Future?
Consensus mechanisms like PoW and PoS are essential to running distributed networks securely and crucial for the mass adoption of blockchain technology. For instance, challenges faced in the Blockchain Trilemma, such as lowered levels of decentralization, security, and scalability, are often alleviated through implementing various consensus mechanisms.
As the article has outlined, both PoS and PoW have pros and cons. However, because of environmental and scalability issues that come with PoW, many newer chains have adopted PoS over PoW. One major event that signified the shift in paradigm is the Ethereum Merge which happened in two phases between 6 to 15 September 2022. The crypto space is still nascent, but the successful and groundbreaking Merge heralds an unpredictable yet hopeful future.
This publication is provided for informational and entertainment purposes only. Nothing contained in this publication constitutes financial advice, trading advice, or any other advice, nor does it constitute an offer to buy or sell securities or any other assets or participate in any particular trading strategy. This publication does not take into account your personal investment objectives, financial situation, or needs. Treehouse does not warrant that the information provided in this publication is up to date or accurate.
New to DeFi? If you found this useful, check out our other Learn DeFi articles to dive deeper into the wonderful world of DeFi! Alternatively, browse our Insights section to read more in-depth analyses on the DeFi space. You can also try out our flagship product, Harvest, to get a comprehensive analysis of your DeFi assets. Lastly, subscribe to newsletter updates in the box below!