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Beginner's Guide to Proof of Work vs. Proof of Stake Mining


Blockchain technologies allow multiple participants (computer nodes) to interact and collaborate on a single database in a trustless way - without the need for a centralized server. Each node is responsible for playing its part in updating and securing the database. In the case of cryptocurrencies, this data is an immutable ledger of every transaction that has ever occurred. The ledger is cryptographically secure, meaning that the current ownership of the coins/tokens are verifiable and very difficult to forge.

Transactions are grouped into blocks, with blocks being created at a fixed or reasonably consistent time interval. For Bitcoin, a new block is created approximately every 10 minutes. Others are much faster - for instance Cardano - where a new block is created every 20 seconds. With each block, the recent transactions must be grouped together and 'signed' by a node in order to be added to the ledger. Only one node can sign each block, so who decides which node this should be? This is where consensus algorithms come in.


Consensus Algorithms


We can think of the mining process to be similar to a lottery draw, and consensus algorithms are simply a rule to determine what counts as a valid ticket. Participants (miners) can possess multiple tickets and use these to increase their chances of being the one that creates the next block. The incentive for creating blocks is generally in the form of a 'block reward' - a fixed amount of coins which are paid to the miner in return for creating the block. To get into more detail, we need to explore each consensus algorithm separately.


Proof of Work


Let's start with Proof of Work, as this is the most common consensus algorithm; it's currently used by Bitcoin, Ethereum and many other mainstream cryptocurrencies. With Proof of Work systems, we can think of each lottery ticket as being a unit of computing power (referred to as the 'hashrate' - i.e. the number if cryptographic hashes it can perform in a second). The greater the hashrate of a node, the more 'tickets' it has in the draw, and therefore the higher chances it has of creating the next block and earning the block reward. Nodes must prove their hashrate by solving a complex mathematical problem; one that exists only to prove the node has the power to solve it. You can learn more about the details of proof of work mining here, as these details aren't necessary to grasp the basic concept.

The proof of work algorithm is secure, as for widely used coins such as Bitcoin it would require enormous amounts of computing power (more than all the world's supercomputers put together) for an attacker to compromise the network. However, this comes with a huge tradeoff: there is masses of energy waste.

Bitcoin blocks are fixed at every 10 minutes on average and each block is of a limited size (1MB). In practice, this means that the upper limit of the Bitcoin blockchain is around 7 transactions per second (since only a certain amount of transactions can fit into each block). Therefore, adding more miners doesn't increase the capacity of the network at all - it only increases the amount of 'tickets' being entered into the draw. And since there can be only 1 winner every 10 minutes, all of the other losing 'tickets' (i.e. masses of computations) were essentially wasted on nothing.

At the time of writing, Bitcoin mining uses more energy than the entire country of Ecuador or Ireland. As more miners get on board, this problem can potentially get a lot worse. This is a huge problem for the environment, and also potentially a barrier to mass adoption of cryptocurrencies. Proof of Stake aims to solve some of these problems.


Proof of Stake


In Proof of Stake systems, the number of tickets a node possesses equates to the quantity of coins held in its accompanying wallet. The more coins a node owns, the more chances it has of being selected to solve the next block. This is referred to as their 'stake'. Hashrate is mostly taken out of the equation, as each node must possess only enough computing power to create and sign a block. This is next to nothing when compared with the processing power spend on proof of work. And since only one node signs each block, there is minimal duplication of tasks across the network.

For an attacker to compromise a network using the proof of stake consensus algorithm, they would generally need to possess or control at least 51% of the total stake. For established cryptocurrencies, this would be an enormous investment. There's also an argument that there would be little incentive for someone to disrupt a currency of which they are the primary stakeholder. For these reasons, we can assume that, on the surface, proof of stake achieves the same security and decentralisation as proof of work, without the wasted energy trade-off.

Proof of stake algorithms essentially merge the gap between miners and investors, since all coin holders are immediately entitled to earn rewards in return for participating in the network, without any additional hardware. We see this as a fundamental shift in the cryptocurrency ecosystem, and it's possible that the majority of blockchains will switch away from Proof of Work in the long term. Ethereum is planning on switching over to Proof of Stake in the near future, which may trigger many others to follow suit.


Potential issues with Proof of Stake


There are a couple of practical issues which may prevent retail investors getting involved with proof of stake mining (known as 'staking'):

  1. Nodes must be left running at all times. This means leaving a computer online 24/7 in order to maximise exposure to rewards. There are power costs (and potentially hardware costs) associated with this, not forgetting that power cuts or internet connection issues could cause reward opportunities to be missed.

  2. Since the node is always online, the wallet is too. This is known as a 'hot wallet', and its contents run the risk of being lost due to hackers or other security compromises.

  3. Unless the node owns a large stake, the frequency of reward payouts will be very low. This could mean going for months or even years without a payout.

Cardano aims to solve these issues using something called 'Delegation', which is estimated to be available from Q3 2018.


Delegation


Cardano holders will have the ability to delegate any or all their stake to another node, whilst still maintaining full ownership and control of their coins. It will even be possible to keep these coins completely offline in something such as a Ledger wallet whilst still staking these coins in the network (details TBC). This solves the security issues, but who should users delegate their stake to?


Staking Pools


Staking pools exist for this exact reason: to provide reliable nodes which participate in the network on behalf of stakeholders. Since pools combine the staking power of multiple users, they also help ensure that users receive frequent payouts. This is because the pool has a much greater chance of being selected to create the next block than an individual user would on their own. Once the pool creates a block and earns the block reward, it is distributed proportionally to all participators in the pool, based on their stake.


Summary


With staking pools, investors can earn frequent rewards (dividends) on their coin holdings without the risk, inconvenience or variance of running their own node. The stake simply needs to be delegated to the pool, which will participate in the network on their behalf, and pay out rewards on a frequent basis.

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