Weekly Market Update - Friday, April 14, 2023

Crypto Topic of the Week: Consensus Mechanisms — Proof of Work (PoW) and Proof of Stake (PoS)

Blockchain networks can vary considerably in their design, particularly with regard to the consensus mechanisms used to perform the essential task of verifying network data. The most common consensus mechanisms are Proof of Work (PoW) and Proof of Stake (PoS). Each design has different implications for the underlying blockchain’s security, accessibility, and energy consumption.

This week, amidst all the news around Ethereum staking and bitcoin (BTC)’s continued rise, we touch on one of the major differences between the two leading blockchains — consensus mechanisms — and explore PoW and PoS.

Consensus Mechanisms in Crypto

A consensus mechanism is the process through which a distributed network reaches an agreement about information on the network — for example, whether transactions are valid and in what order they occur. Consensus mechanisms also play a key role in securing blockchain networks.

Most public blockchain networks today use processes referred to as Proof of Work (PoW) or Proof of Stake (PoS) to provide consensus.

Proof-of-Work (PoW) Blockchains

The PoW consensus mechanism was popularized first by Bitcoin, and has played a foundational role in the crypto ecosystem.

How PoW blockchains work. Among the defining components of PoW systems are miners and the energy they use to make calculations that verify transactions. Miners operate computer hardware to run network nodes that employ computational power to algorithmically solve mathematical puzzles called proofs of work.

The miner who solves the puzzle first confirms the most recent block of transactions on the blockchain, and broadcasts the new block to all other nodes. Other nodes confirm the accuracy of the block and add it to their copy of the blockchain, building a verifiable record of network data. This verification process represents consensus, and only once this data is confirmed can a new block be added to the network.

Miners receive newly minted crypto, the block reward, (in the case of Bitcoin, they receive BTC) for being the first to validate a new block of data and add it to the PoW blockchain.

Despite some limitations related to speed and scalability, PoW blockchains have historically provided strong security, while maintaining meaningful decentralization. Since PoW systems are distributed, it is usually prohibitively expensive for a malicious actor to take over the blockchain by controlling the majority of computing power on the network. The hardware, electricity, and computational costs are typically too high to surmount.

Learn more about how PoW plays into network security here.

Proof-of-Stake (PoS) Blockchains

PoS has been in the news recently, with Ethereum’s transition from PoW to PoS being followed by various high-profile network upgrades, including Shapella this week.

Current industry-leading blockchains that use PoS in whole or in part include Polkadot, Avalanche, Cardano, Cosmos, Solana, and Ethereum.

How PoS blockchains work. Instead of miners validating transactions, PoS blockchains use validators. Validators are network node operators that validate data, similarly to PoW systems, but without the energy-intensive computational process to earn the right to validate.

Instead of working to solve proofs of work, validators “stake” a blockchain’s native tokens in a bid to become eligible for selection as a validator node. A prospective validator on a PoS blockchain will essentially stake crypto tokens to serve as collateral. When it comes time to validate data held in a transaction block, the PoS system randomly selects a validator to confirm the data.

When the block is confirmed, that validator is typically rewarded with network transaction fees, and the process begins with a new block.

Learn about the variety of different PoS consensus mechanisms here.

PoS blockchains keep blockchain networks secure and validators honest by requiring validators to stake their tokens. If validators act maliciously or incompetently, they may lose their staked tokens and access to the network through a process typically called “slashing.” This incentive structure ensures that validators have more to gain from being an honest actor than by breaking the rules.

The barrier to entry to PoS blockchains for validators is arguably lower than with PoW for miners, though a sufficient amount of crypto to stake is still required for PoS validators.

Innovation is a constant in the crypto industry, and so it’s no surprise that various other consensus mechanisms have been developed beyond PoW and PoS. Explore the variety of different blockchain consensus mechanisms here.

See you next week. Onward and Upward!

Team Gemini

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