Cryptocurrencies like Bitcoin aren’t attached to any central government or bank. There isn’t any physical, tangible source of their value that you can picture and hold. Instead, what sets it apart from Fiat currency and gives it immense value is its cryptography. Crypto is a trustless system, meaning it algorithmically verifies and validates transactions to prevent fraud.
The two most popular methods of verification are Proof of Work and Proof of Stake. Proof of Work pits miners against each other, in a competition to solve complex algorithms. The people with the best computational power will win. It’s like a footrace where anything goes, the person with the most sand to throw into the other racers eyes will win.
Proof of Stake is less computationally intensive. Instead, people who want to verify blocks need to put up a pricey deposit. If they cheat or let through fraudulent transactions, they lose their stake. It’s equivalent to a deposit for renting a house or apartment. If you destroy the house by the end of your renting term, you lose the money.
Understanding how crypto is verified and validated will make you a savvier investor. You’ll understand crypto, blockchain, and its usage in a clearer way. You’ll learn that there isn’t really a series of elaborate underground mines laced with different cryptocurrencies.
Proof of Work
Bitcoin and many other cryptocurrencies incentivize people around the world to help validate and verify these transactions. But how do you prove that you did the work, and therefore deserve the reward? On a math test in school, you wouldn’t get full marks for answering without proving that you did the work to arrive at the answer legitimately.
What does showing your work in grade school have to do with Bitcoin? Actually, that’s the way Bitcoin and other blockchains ensure that the data they add to the blockchain is valid. Showing the work ensures that I can’t sneak in an extra 10 BTC into my wallet. This method of validation is called Proof of Work.
When transactions on the blockchain occur, this information is written down. For example, Address A sent 0.005 BTC to Address B. This transaction is grouped with a bunch of other transactions into a block. The block comes with a puzzle that is then broadcast to the rest of the bitcoin network.
A miner needs to solve this puzzle to verify the block, adding it to the blockchain. Miners compete to solve these algorithmic puzzles that require a lot of computational power to calculate. However, they are incredibly easy to verify. It’s like putting together furniture, it is really easy to check afterwards if you did it correctly. But it is not so easy to put it together, and that’s why you don’t need centralization of authority. Nearly anyone can see if a transaction is fraudulent.
The first miner who solves these cryptographic puzzle problem broadcasts the block to the rest of the network. Other miners can then easily verify and validate the answer to this algorithm. The miner is then rewarded with some crypto, (called a block reward) issued to their public address. Their answer provides their Proof of Work.
A Proof of Work system allows for the secure processing of peer-to-peer transactions. It doesn’t require a third party to validate or verify the Bitcoin transactions. This creates a trustless system and prevents people from spending the same crypto twice.
You can’t alter the Bitcoin blockchain unless you own 51% or more of all the mining machines. That way, you’d be able to introduce fraudulent blocks but have enough mining rigs to falsely verify them. It’s like rigging an election. For Bitcoin, these attacks are extremely expensive and thus unlikely (but not impossible) to target cryptos with a large market cap like Bitcoin.
Coins with smaller market caps have been targeted in the past. In 2016, two projects on the Ethereum network’s sidechain called Krypton and Shift suffered from 51% attacks. In 2018, a larger 51% attack targeted Bitcoin Gold, resulting in more than $18 million in losses.
Proof of Work requires a lot of computer power and specialized hardware. If we tried mining Bitcoin on a regular laptop, it would either heat up and burn out, or slow it down so much that we defenestrate it.
Unfortunately, it also means that you need a lot of money to set up a mining rig, and you’ll expend a lot of energy getting it to run. It might not even end up profitable for you.
Proof of Work also requires a bit of luck to be the first machine to arrive at the correct solution.
Proof of Stake
In 2011, another algorithmic method for validating transactions came into development. Called Proof of Stake, it would replace miners with validators. Rather than receiving mining rewards, validators are incentivized by minting or forging new crypto.
You’re basically betting a lot of money that you’ll be an honest validator.
You need to deposit a certain amount of crypto into the network. Think of the television show Impractical Jokers. Four friends compete in challenges, staking their shame and dignity. The loser of these challenges will then ‘lose’ their stake and need to do something uniquely shameful. When someone cheats in Impractical Jokers, they lose their challenges and can also lose their stake.The risk of losing is insurance for the (TV) network.
The higher your stake, the higher the chance that you can mint or forge the next block. Once your machine validates the block, (called stake consensus) you are rewarded. If a fraudulent transaction is approved, the machine will lose the stake. Similarly, The value of the stake is higher than the value you’d receive from validating fraudulent blocks.
In the Proof of Stake system, miners don’t compete for the same block. This saves an enormous amount of energy and computational power. There is a lower barrier to entry because one doesn’t need to purchase fancy computing power and pay high energy bills. Instead, people can use cheaper hardware to set up staking. As a result, a POS System leads to a more decentralized blockchain network of validators.
Proof of Stake may also fall victim to the 51% attack. But it is much more expensive to execute this attack because you need to own 51% of all the coins in circulation. Meanwhile, for a Proof of Work currency, you simply need to have the most computational power. Additionally, there is a risk that a validator’s machine is selected but fails to do the work for whatever reason. The blockchain needs to set up backup validators in case the original fails.
But, richer investors will have a higher probability of becoming validators for any one block. This continues to be a major limitation across many blockchains and validation solutions.
Proof of Burn
Some people just want to watch the world burn. If you’re one of them, or perhaps Heath Ledger’s Joker from Christopher Nolan’s The Dark Knight, this validation method is for you. Unfortunately, you can’t use an actual flame to validate blocks in the blockchain. We here at Hello Crypto advise against applying fire or flames to your hardware when attempting to validate a transaction.
Proof of Burn situated itself as an energy-friendly alternative to Proof of Work. To receive blocks to validate, you need to burn some crypto. When we say burn, we simply mean sending crypto to a verifiably unspendable address. This grants you the ability to mine a certain amount of blocks proportional to the amount of crypto that you burnt. The power of burnt coins decreases each time a new block is mined, preventing the earliest adopters from receiving an unfair advantage.
Proof of Burn introduces deflation, where part of the transaction fees from each transaction are essentially destroyed. More of the supply continues to be burnt, increasing the value of the rest of the tokens. In addition, it eliminates competition between miners, thus reducing the energy requirements and cost for mining. The added effect of this system is a quicker, more agile network for validating blocks making it’s scalability much more efficient.
Proof of Burn has similar disadvantages as Proof of Stake. Mainly, people with more of the crypto can validate more transactions, receiving more of the rewards. Like any other crypto, it faces the risk of a 51% attack, though it is less likely since someone would need to buy 51% of all the cryptocurrency.
Proof of Space and Time
Proof of Space and Time, has nothing to do with astrophysics or Albert Einstein. While we adhere to the laws of physics, we also recognize that Proof of Space and Time is also a crypto validation method.
A new crypto called Chia proposes a new validation method that relies on unused hard drive disk space. It is very similar to Proof of Work, though instead of computational power it requires unused hardware space. You can seed unused space by installing software that will store collections of cryptographic numbers. These are called plots, and the users are called farmers.
The blockchain will then broadcast the hash for a cryptographic block. Farmers that have the number closest to this hash can validate the block. The probability of getting a block that you can validate depends on how much space the farmer has allocated.
Proof of time institutes a consensus algorithm that takes a certain amount of time to compute, called a Verifiable Delay Function. However, it is very fast to verify. For these functions, you can’t use parallel machines or more power. Using more computer power won’t translate to quicker mining, saving energy.
The first person to verify the block will receive a reward, and it will be added to the blockchain. Think of it like buying a bunch of lottery tickets – the more tickets you have, the greater your chances of getting the reward.
It is cryptographically secure and there is a low barrier to entry. You simply need to buy an enterprise-quality external hard drive. It uses less energy because of the Verifiable Delay Function. This function consists of a bunch of easy stepwise calculations, making it futile to add more powerful hardware to your machine.
While this protocol won’t waste immense amounts of energy, it will lead to shortages of hard drives. Plotting Chia shortens the lifespan of these hard drives, leading to higher demand and more electronic waste. As it stands, people who can purchase more hard drives will be at an advantage as they will have larger plots.
The Future of Validation
Different methods of validation or reaching consensus still share similar issues. These methods will still provide people with more money and resources, more chances to act as miners, validators, or farmers. Truly democratizing cryptocurrency would require a validation method that lowers the barrier to entry. Anyone with a laptop would be able to participate, regardless of how much of a cryptocurrency they own.
That is, of course, much easier said than done. I mean, you try to develop an entire system of validating transactions. A lot of blockchains will use variations of these four types of validation methods. In general, adding a twist or two like a time delay can further democratize validation.
What Difference Does It Make?
Glance out your window and gaze upon the ecological destruction the last few decades brought on. Oceans are catching fire and Canadian towns are getting so hot that they’re burning down. For us, it is difficult to make any investment decisions without taking into account the environment.
When we support cryptocurrencies and blockchain protocol changes that emphasize lower energy usage, we develop a more sustainable financial ecosystem. As clean energy becomes cheaper and more widely adopted, it might make Proof of Stake more sustainable.
The Environmental Cost of Ethereum and Bitcoin
As of right now, both of these blockchains use a Proof of Work validation approach. As of right now, the mining power used for a year of Bitcoin is comparable to Sweden. Right now, Ethereum’s (eth) Proof of Work validation uses half as much electrical energy as Bitcoin, every year. However, Ethereum is slowly disincentivizing mining and shifting to a Proof of Stake system. This may reduce energy consumption by more than 99%.
Even if clean energy is used for mining Bitcoin, it will draw ire from critics that don’t see it as a worthy blockchain technology, at least not in the current climate crisis. Would the energy be better used if it were directed elsewhere or even into another blockchain? Investing in the future means looking for blockchain solutions that are energy-efficient and more democratized.
The value of crypto lies within its validation methods. This allows a group of independent nodes, validators, or miners to reach a consensus. A consensus will validate a new block that is added to the blockchain. Validators are then rewarded for participating in this process. Of course, none of these validation methods are perfect.
Proof of Work, the method associated with Bitcoin requires miners to solve difficult puzzles. It requires a lot of energy and specialized computer hardware. The second most well-known method is called Proof of Stake. Rather than using difficult puzzles to verify transactions, it takes a “deposit” from each validator. If a validator passes fraudulent transactions, they lose their deposit.
We’ve summarized these different methods, including the lesser known Proof of Burn and Proof of Space and Time here for you.