In August 2017, when I was first delving into Bitcoin, there was a big technical development that saw the creation of an alternative cryptocurrency to Bitcoin, imaginatively called Bitcoin Cash. Maybe it’s just coincidence, but summer seems to be a popular time for big changes, because the 2nd largest crypto in terms of market value, Ethereum, is going to go through a huge technical development of its own next month, that will shape the future of the project. It’s all to do with switching from Proof of Work to Proof of Stake, terms you may have heard of. But what do they mean and why are they important?
1. Consensus Mechanism
Bitcoin is a decentralised ledger, which simply means it’s a database that’s maintained by many unconnected computers running the Bitcoin software. Other cryptocurrencies are based on the same idea of a decentralised ledger, although many debate how decentralised and unconnected the computers running each currency are. When there is an update to the database, all the computers maintaining the ledger have to agree that those are the changes to be made, therefore achieving consensus. The Consensus Mechanism is the way that they do it and the two methods we’ll cover are Proof of Work and Proof of Stake.
2. Proof of Work
Bitcoin uses Proof of Work, where the computers (miners) race to solve a puzzle. Think of it like 100s of people trying to complete a jigsaw puzzle. When you see all the pieces together correctly, everyone in the race can quickly agree that the picture is correct, while if there is piece missing or in the wrong place, it’s relatively easy to spot. The winning computer gets to update the ledger with the information held in the puzzle. There are a few other crypto projects that use proof of work, some of the biggest ones being Ethereum (currently), Dogecoin, Litecoin and Monero.
3. Proof of Stake
With Proof of Stake, the computers (validators) are chosen based on the number of tokens that they are willing to stake in the system. The theory being that if the participant has a stake in the system, then it’s in their best interest to act properly and securely update the ledger. In a nutshell, with Proof of Work the computers have to spend energy as the resource whereas in Proof of Stake, they have to spend money on the token of the project as the resource.
4. The Pros
Proof of Work has been securing Bitcoin for years now without any downtime and is the most proven method to achieving large scale consensus so far. While it uses significant energy, proponents argue that it incentivises renewable resources that are cheapest.
Proof of Stake should be much less energy intensive, increase the volume and speed of transactions and should reduce network fees.
5. The Cons
Proof of Work uses energy, which many feel can be put to better uses. See Bullet No.4 and No.10 for more detail here. There are many concerns that Proof of Stake risks security, can lead to manipulation and coordination by wealthy actors, essentially achieving centralisation, and threat of shutdown by authorities. Bitcoin Magazine have done a great analysis of the potential pitfalls for the more technically minded
The cost of entry for either system via miners or validators can be very high, starting in the $1000s, which can limit the number of participants. The less participants, then the less decentralised a system is, so something to be wary of on both sides.
6. The Debate
Via a merge, to a Proof of Stake system, Ethereum are wanting moving away from Proof of Work that has served them well so far. Bitcoin will continue to run Proof of Work and the debate is raging about which will be better or worse. Bitcoiners are being very vocal about security risks, which is absolutely the right thing to highlight, while others focus on the benefits to scaling that a switch to Proof of Stake may bring. Bitcoin is trying to scale via layers and maintain security, instead of on the main chain via a change to something like Proof of Stake.
Ultimately, if Proof of Stake is less secure then it will be exploited like other projects have recently and the project will likely collapse. Ultimately, the market will decide which currency they see has the more value to them going forward, like they’ve done with Bitcoin and Bitcoin Cash. I’ll play it that way too and am happy to be a bystander while waiting to see how it all plays out. You can read more about the Merge here.
Peace, love, and Bitcoin,
Rob