Economies of mining
You might have read articles online saying that cryptocurrencies like Bitcoin uses enormous amounts of energy to secure their networks. But why is that - and more importantly - what are the alternatives? Mining new coins takes a lot of computing power because of the proof-of-work algorithm. The idea was first introduced in 1993 to combat spam emails and was formally called ?proof-of-work? in 1997. However the technique went largely unused until Satoshi Nakamoto created Bitcoin in 2009. He realized that this mechanism could be used to reach consensus between many nodes on a network and he used it as a way to secure the Bitcoin blockchain.
However, the proof-of-work algorithm works by having all nodes solve a cryptographic puzzle. This puzzle is solved by miners and the first one to find the solution gets the miner reward. This has led to a situation where people are building larger and larger mining farms like this one. According to Digiconomist, Bitcoin miners alone uses about 54 TWh of electricity, enough to power 5 million households in the US or even power the entire country of New Zealand or Hungary. But it doesn?t stop there. Proof-of-work gives more rewards to people with better and more equipment. The higher your hash rate is, the higher the chance that you?ll get to create the next block and receive the mining reward. To increase chances even further, miners have come together in what?s called ?mining pools?.
They combine their hashing power and distribute the reward evenly across everyone in the pool. So to sum it up: proof-of-work is causing miners to use massive amounts of energy and it encourages the use of mining pools which makes the blockchain more centralized as opposed to decentralized. So to solve these issue?s we have to find a new consensus algorithm that is as effective or better then proof-of-work. In 2011 a Bitcointalk forum user called QuantumMechanic proposed a technique that he called ?proof-of-stake?.
The basic idea is that letting everyone compete against each other with mining is wasteful. So instead proof-of-stake uses an election process in which 1 node is randomly chosen to validate the next block. Oh yeah, small difference in terminology there. Proof-of-stake has no miners but instead has ?validators? and it doesn?t let people ?mine? blocks but instead ?mint? or ?forge? blocks. Validators aren?t chosen completely randomly. To become a validator, a node has to deposit a certain amount of coins into the network as stake. You can think of this as a security deposit. The size of the stake determines the chances of a validator to be chosen to forge the next block. It?s a linear correlation.
Let?s say Bob deposits $100 dollars into the network while Alice deposits $1000. Alice now has a 10 times higher chance of being chosen to forge the next block. This might not seem fair because it favors the rich, but in reality it?s more fair compared to proof-of-work. With proof-of-work rich people can enjoy the power of economies at scale. The price they pay for mining equipment and electricity doesn?t go up in a linear fashion. Instead the more they buy, the better prices they can get. Economies at scale!
But back to proof-of-stake. If a node is chosen to validate the next block, he?ll check if all the transactions within it are indeed valid. If everything checks out, the node signs off on the block and adds it to the blockchain. As a reward the node receives the fees that are associated with each transaction. Okay but how can we trust other validators on the network? Well that?s where the stake comes in. Validators will lose a part of their stake if they approve fraudulent transactions. As long as the stake is higher then what the validator gets from the transaction fees, we can trust them to correctly do their job. Because if not, they lose more money then they gain.
It?s a financial motivator and holds up as long as the stake is higher then the sum of all the transaction fees. If a node stops being a validator, his stake plus all the transaction fees that he got will be released after a certain period of time. Not straight away because the network still needs to be able to punish you, should they discover that some of your blocks where fraudulent. So the differences between Proof-of-work and Proof-of-stake are quite significant. Proof-of-stake doesn?t let everyone mine for new blocks and therefore uses considerably less energy.
It?s also more decentralized. How is that? Well in proof-of-work we have something called mining pools. Those are people who are teaming up to increase their chances of mining a new block and thus collecting the reward. However these pools now control large portions of the bitcoin blockchain. They centralize the mining process and that?s dangerous. If the three biggest mining pools would merge together, they would have a majority stake in the network and could start approving fraudulent transactions.
Another important advantage is that setting up a node for a proof-of-stake based blockchain is a lot less expensive compared to a proof-of-work based one. You don?t need expensive mining equipment and thus proof-of-stake encourages more people to set up a node, making the network more decentralized and also more secure. But even proof-of-stake isn?t perfect and it also has some flaws. You might think: ?hold on a minute! If I buy a majority stake in the network, I can effectively control it and approve fake transactions? and you would be correct. This is called the 51% attack and was first discussed as a weak point of the proof-of-work algorithm. If a single miner or group of miners can obtain 51% of the hashing power, they can effectively control the blockchain.
Proof-of-stake on the other hand makes this attack very impractical, depending on the value of a cryptocurrency. If Bitcoin would be converted to proof-of-stake, acquiring 51% of all the coins would set you back a whopping 79 billion dollars. So the 51% attack is actually less likely to happen with proof-of-stake. But that?s not the only risk. Proof-of-stake algorithms also have to be careful how they select the next validators.
It can?t be completely random because the size of the stake has to be factored in. But at the same time the stake alone isn?t enough because that will favor rich people, who will get chosen more frequently, will collect more transaction fees, become even richer and thus increase their chances of being chosen as validator even further. There are a number of proposals to fix this like coin age based selection. Another potential problem is when the network choses the next validator but he doesn?t turn up to do his job. This could easily be solved by choosing a large number of backup validators as a fallback.
In short: proof-of-stake brings additional risks when compared to proof-of-work and a lot of research is needed to understand these risks and to mitigate them. Alright so now that we know what proof-of-stake is, what benefits it has and what risks are involved, let?s look at real world usage. A few examples of coins that use it right now are Peercoin, Lisk and Nxt but more cryptocurrencies are likely to follow in the future. Ethereum for instance is working on implementing a proof-of-stake system which they call Casper. It?s currently deployed on the Ethereum testnet and is actively being developed. And also the Cardano project has long been working on creating the a provable secure proof-of-stake algorithm that they call Ouroboros.