As mentioned at the end of Part One of the Introduction to Cryptocurrency, this blog post will further explore fundamental concepts of Cryptocurrency beginning with Proof of Work and Proof of Stake.
What are Proof of Work and Proof of Stake?
Suppose there is a cryptocurrency called “Crypto.” In order to obtain a unit of “Crypto”, miners must contribute to the blockchain by verifying the legitimacy of previous transactions. If this task is easy and not costly, then the number of issued “Crypto” units will continue to grow and an extremely fast rate resulting in inflation and making “Crypto” worthless.
To counteract this form of inflation and ensure there is a general consensus on transactions, Cryptocurrencies will implement either Proof of Work or Proof of Stake systems.
Proof of Work
The first system we will explore is the Proof of Work system. In this system, miners are given complex problems that are difficult to solve, but simple to verify. The solution to this problem will result in the formation of a new block which contains all confirmed transactions and miner who has added to the blockchain will be rewarded with a newly created cryptocurrency unit as a reward.
Currently, Bitcoin has a bounty for 25 Bitcoins for every new block and this amount is halved every 210,000 blocks.
One common criticism with the Proof of Work system is that it requires an incredible amount of computational energy that isn’t very scalable. This leads to a tragedy of the commons and more mining where electricity is cheap. In the case where there are fewer miners, the network becomes vulnerable to a 51% attack where a single entity owns 51% of the network. This would allow the entity to create fraudulently modify the transactions of the blockchain.
Proof of Stake
The second system is called Proof of Stake and has been introduced as an alternative to solve some of the issues of Proof of Work. In the Proof of Stake system, a miner’s mining power is dependent on the number of coins he or she holds. In practice this means that the creator, or forger of the new block is chosen in a pseudo-random way dependent on the miner’s wealth.
When the creator is chosen, their coins are held in an account. If they validate false transactions they will lose their “stake” and their privilege to participate as a forger. The stake incentivizes the forgers to make the correct validations at the risk of losing their stake.
This system does not require exceptional computational power as there is not a competition to solve a problem. However, this system has an initial problem as there is no way to have stake in the system if no one has any coins. Thus, cryptocurrencies that use this system will choose to either sell their pre-mined coins or start in a Proof of Work system and switch to a Proof of Stake system later (Ethereum).