As expected, since we published Crypto TREND we have received many questions from readers. In this edition we will answer the most common.
What kind of changes are coming that could be a game changer in the cryptocurrency sector?
One of the biggest changes that will affect the world of cryptocurrencies is an alternative method of block validation called Proof of Stake (PoS). We’ll try to keep this explanation fairly high level, but it’s important to have a conceptual understanding of what the difference is and why it’s a significant factor.
Remember that the underlying technology with digital currencies is called blockchain and most digital currencies today use a validation protocol called Proof of Work (PoW).
With traditional payment methods, you must trust a third party such as Visa, Interact, a bank, or a check clearinghouse to settle your transaction. These trusted entities are “centralized,” which means they maintain their own private ledger that stores the transaction history and balance of each account. They will show you the transactions and you have to agree that it is correct or start a dispute. Only the parties to the transaction see it.
With Bitcoin and most other digital currencies, the ledgers are “decentralized,” which means everyone on the network gets a copy, so no one has to trust a third party, like a bank, because anyone can verify the information directly. This verification process is called “distributed consensus.”
PoW requires “work” to be done to validate a new transaction to enter the blockchain. With cryptocurrencies, that validation is done by “miners”, who must solve complex algorithmic problems. As algorithmic problems become more complex, these “miners” need more expensive and powerful computers to solve the problems before everyone else. “Mining” computers are often specialized and typically use ASIC (Application Specific Integrated Circuits) chips, which are more adept and faster at solving these difficult puzzles.
Here is the process:
- Transactions are grouped together in a ‘block’.
- Miners verify that the transactions within each block are legitimate by solving the hash algorithm puzzle, known as the “proof-of-work problem.”
- The first miner to solve the block’s “proof of work problem” is rewarded with a small amount of cryptocurrency.
- Once verified, the transactions are stored on the public blockchain throughout the network.
- As the number of transactions and miners increase, the difficulty of solving hashing problems also increases.
Although PoW helped get blockchain and decentralized and trustless digital currencies up and running, it has some real shortcomings, especially with the amount of electricity consumed by these miners trying to solve “proof-of-work problems” as quickly as possible. According to Digiconomist’s Bitcoin Energy Consumption Index, Bitcoin miners use more energy than 159 countries, including Ireland. As the price of each Bitcoin increases, more and more miners try to solve the problems, consuming even more energy.
All that energy consumption just to validate transactions has motivated many in the digital currency space to look for an alternative method of validating blocks, and the leading candidate is a method called “Proof-of-Stake” (PoS).
PoS is still an algorithm and the purpose is the same as Proof of Work, but the process to reach the goal is quite different. With PoS, there are no miners, instead we have “validators”. PoS is based on trust and the knowledge that all the people who validate the transactions have their skin in the game.
In this way, instead of using energy to answer PoW puzzles, a PoS validator limits itself to validating a percentage of transactions that reflects its ownership stake. For example, a validator that owns 3% of the available Ether can theoretically validate only 3% of the blocks.
In PoW, the chances of you solving the proof of work problem depend on how much computing power you have. With PoS, it depends on how much cryptocurrency you have in “play”. The higher the bet you have, the better the chances that you will solve the block. Instead of earning cryptocurrency, the winning validator receives transaction fees.
Validators deposit your stake by ‘locking’ a portion of your funds tokens. If they try to do something malicious against the network, such as creating an ‘invalid block’, they will lose their stake or security deposit. If they do their job and do not violate the network, but do not win the right to validate the block, they will get their stake or deposit back.
If you understand the basic difference between PoW and PoS, that’s all you need to know. Only those who plan to be a miner or validator should understand all the ins and outs of these two validation methods. Most of the general public who want to own cryptocurrency will simply buy it through an exchange and will not participate in mining or validating block transactions.
Most in the cryptocurrency industry believe that for digital currencies to survive in the long term, digital tokens need to shift to a PoS model. At the time of writing this post, Ethereum is the second largest digital currency behind Bitcoin and its development team has been working on its PoS algorithm called “Casper” for the past few years. We are expected to see Casper implemented in 2018, putting Ethereum ahead of all other major cryptocurrencies.
As we have seen in this sector before, major events like a successful Casper implementation could drive Ethereum prices much higher. We will keep you posted in future issues of Crypto TREND.
Stay tuned!