A look into the foundation of cryptocurrency: consensus mechanisms. Why do different consensus mechanisms exist, is Proof of Work actually “environmentally unfriendly”, and why Proof of Stake deserves the alternative transcription to its abbreviation.
POV: You’ve been critically thinking, which led to an attempt at educating yourself on cryptocurrency, finance’s future and freedom. But now that you trudge beyond sensational headlines and courthouse media coverage, the horizon is terrifyingly vast and populated by vocabulary of the unknown.
Giving up and sticking to the dollar and its sticky trust seems much easier, but at the ripe age of old having to labor and argue for the right to your own pennies at the bank will be an infinitely more unpleasant toll than making the effort to learn today.
An essential concept making up the foundation of cryptocurrency and blockchain technology is the consensus mechanism. Rather, consensus mechanisms. After all, when Bitcoin was released, it pioneered an entirely different way of governing the money system.
To understand the significance and opportunities offered by cryptocurrency and blockchain technology, understanding a governance completely unlike the one we are used to with fiat is a solid place to start.
What is the role of a consensus mechanism?
In a cryptocurrency network, a consensus mechanism is used to ensure that all the nodes in the network agree on the state of the blockchain. This is necessary to prevent double-spending and ensure the integrity of the ledger.
The consensus mechanism is responsible for validating transactions and adding new blocks to the blockchain. In a decentralized network, there is no central authority that can validate transactions or make decisions about the state of the network. Instead, a consensus mechanism is used to allow nodes in the network to reach agreement on the state of the blockchain.
Different consensus mechanisms use different methods to achieve consensus. For example, in Proof of Work (PoW), miners compete to solve a mathematical problem to add a new block to the blockchain. In Proof of Stake (PoS), validators are chosen to add new blocks based on the amount of cryptocurrency tokens they have “staked” or locked up as collateral. Delegated Proof of Stake (DPoS) allows token holders to vote for a small number of delegates who are responsible for validating transactions and adding new blocks to the blockchain.
The consensus mechanism plays a crucial role in ensuring the security, scalability, and performance of a cryptocurrency network. It determines the rules for validating transactions, adding new blocks to the blockchain, and maintaining the integrity of the ledger. By achieving consensus, the cryptocurrency network can operate in a decentralized and trustless manner, without the need for a central authority.
The fiat equivalent of a consensus mechanism is monetary policy implemented by the central bank of a country. The central bank is responsible for regulating the money supply, setting interest rates, and implementing policies to manage inflation, ensure financial stability, and promote economic growth.
The central bank exercises consensus by setting monetary policy goals and using various tools to influence the money supply and interest rates in the economy. For example, the central bank may adjust the reserve requirement for commercial banks, engage in open market operations to buy or sell government bonds, or adjust the discount rate at which other banks can borrow money from the central bank.
Monetary policies are intended for maintaining confidence in the currency and ensuring its acceptance as a medium of exchange and store of value, as well as ensuring financial stability, preventing systemic risks and maintaining trust in the financial system.
What’s wrong with monetary policy?
Indeed, what’s wrong with letting the central bank tweak the value and regulation of your own money, in accordance with what is beneficial to the government and bank?
Common outcomes of monetary policies result in:
- Inflation: If the central bank increases the money supply too much or keeps interest rates too low for too long, it can lead to inflation. This can erode the value and purchasing power of the currency, and make it more expensive to buy goods and services.
- Deflation: Conversely, if the central bank tightens monetary policy too much, it can lead to deflation. Deflation can be just as harmful to the economy as inflation, as it can reduce consumer spending and investment, and make it more difficult for businesses to make a profit.
- Financial instability: Monetary policies contribute to financial instability. Low interest rates and loose monetary policy can encourage risky borrowing and lending practices, leading to asset bubbles and financial crises.
- Unequal distribution of wealth: Among the younger generation, the idea of ever having enough money to purchase real estate is completely infeasible, and not because of laziness. Low interest rates and quantitative easing can increase the value of assets such as stocks and real estate, which can benefit the wealthy more than the average person.
- Currency devaluation: In extreme cases, monetary policies can lead to currency devaluation, which can cause a loss of confidence in the currency and lead to capital flight.
Cryptocurrency addresses these monetary policy flaws in several ways:
- Inflation: Many cryptocurrency have a fixed supply or a limited inflation rate that is predetermined by the protocol. This eliminates the risk of hyperinflation or currency devaluation that can occur with traditional fiat currencies.
- Deflation: Cryptocurrency can avoid deflation by allowing for the creation of new coins to incentivize network participation, without the need for interest rates.
- Financial instability: Cryptocurrency is decentralized and not controlled by a central authority, which reduces the risk of financial instability caused by central bank policies. Additionally, cryptocurrency allows for greater transparency and accountability in financial transactions, reducing the risk of fraud and corruption.
- Unequal distribution of wealth: Cryptocurrency is more accessible to a wider range of people, including those without access to traditional banking services. Additionally, the decentralized nature of cryptocurrency can reduce the concentration of wealth among a small group of individuals or institutions.
- Currency devaluation: Cryptocurrency is not tied to any government or central authority, which means it is not subject to the same risks of currency devaluation.
This doesn’t mean that cryptocurrency is lawless. But in the age of technology and complex algorithms, regulation is possible without authority, and perhaps a truly principled governance is possible for the very first time.
Governance without governor
A consensus mechanism is a set of rules and protocols that govern how transactions are verified, validated, and added to a blockchain in a decentralized manner. In a cryptocurrency network, the consensus mechanism ensures that all nodes on the network agree on the current state of the ledger, and that no fraudulent or malicious transactions are accepted.
The most common consensus mechanisms used in cryptocurrencies are Proof of Work (PoW), Proof of Stake (PoS), and variations of these mechanisms.
There are several consensus mechanisms that are used in blockchain and distributed ledger technologies. Some of the most common consensus mechanisms are:
- Proof of Work (PoW): In PoW, miners compete to solve a complex mathematical problem in order to validate transactions and add new blocks to the blockchain. The first miner to solve the problem is rewarded with new cryptocurrency tokens. This mechanism is used in Bitcoin and other cryptocurrencies.
- Proof of Stake (PoS): In PoS, validators are chosen to add new blocks to the blockchain based on the amount of cryptocurrency tokens they hold and have “staked” or locked up as collateral. This mechanism is used in cryptocurrencies like Ethereum.
- Delegated Proof of Stake (DPoS): In DPoS, token holders can vote for a small number of delegates who are responsible for validating transactions and adding new blocks to the blockchain. This mechanism is used in cryptocurrencies like EOS.
- Proof of Authority (PoA): In PoA, a small number of trusted nodes are responsible for adding new blocks to the blockchain based on their identity or reputation. This mechanism is used in private and consortium blockchains, like VeChain.
- Byzantine Fault Tolerance (BFT): BFT is a consensus mechanism that uses a voting system to reach agreement on the state of the blockchain. This mechanism is used in permissioned blockchains like Hyperledger Fabric.
There are also other consensus mechanisms such as Practical Byzantine Fault Tolerance (PBFT), Federated Byzantine Agreement (FBA), and Directed Acyclic Graph (DAG), which are used in different blockchain projects.
Why so many?
Since Proof of Work was the initial consensus mechanism developed to govern Bitcoin, why were other consensus mechanisms even created?
As more cryptocurrencies were created, their goals and function varied from that of Bitcoin, the purpose of which is to provide a decentralized, peer-to-peer digital currency that can be used for transactions without the need for intermediaries such as banks, governments, or other financial institutions. In fact, many digital currencies circulating today are created to support blockchain projects.
For a currency intended to replace fiat completely, the best consensus mechanism is the one that provides the most secure, transparent, and decentralized network: Proof of Work.
PoW is known for its security and resistance to attacks, and it is completely decentralized. The drawback? PoW is energy-intensive. This means two things: PoW is less scalable than Proof of Stake, and PoW is less environmentally friendly… not. In fact, the latter is so often written about in traditional media, that many don’t question what this statement actually means.
The less headline friendly scalability issue, however, is already being addressed by projects like Lightning Network.
This leaves only one caveat, if it was ever an issue of the PoW consensus mechanism to begin with.
Is Proof of Work destroying the planet?
No, it’s not. But why is this idea regurgitated so often? Because while Proof of Work uses electricity to carry out its protocol, the ecologically unfriendly factor isn’t PoW, but the source of electricity itself.
While mining requires a significant amount of electricity, nothing on cryptocurrency’s part prevents this electricity from being produced by sustainable and clean energy, like nuclear power. In fact, mining centers directly connected to nuclear power plants are already built in the U.S.
Nuclear energy and PoW cryptocurrency are a match made in decentralized, efficient heaven, for three key reasons:
1. Nuclear energy protects clean air
Nuclear energy is a clean energy source that generates power through the process of fission, which splits uranium atoms to produce energy. Unlike fossil fuels, nuclear energy does not emit harmful byproducts and releases zero emissions. This significantly reduces harmful air pollutants that cause acid rain, smog, lung cancer, and cardiovascular disease.
According to the Nuclear Energy Institute (NEI), nuclear energy helped the United States avoid more than 471 million metric tons of carbon dioxide emissions in 2020, which is equivalent to removing 100 million cars from the road.
2. Nuclear energy has a small land footprint
Despite producing large amounts of carbon-free power, nuclear energy requires less land than any other clean-air source. A typical 1,000-megawatt nuclear facility needs only slightly more than 1 square mile to operate, while wind farms require 360 times more land area to produce the same amount of electricity and solar photovoltaic plants require 75 times more space. To provide a perspective, more than 3 million solar panels or over 430 wind turbines (capacity factor not included) are needed to produce the same amount of power as a typical commercial reactor.
3. Nuclear energy produces minimal waste
Nuclear fuel is extremely dense, making it an efficient energy source. Used nuclear fuel produces waste that is significantly less in volume compared to traditional energy sources. All the used nuclear fuel generated by the U.S. nuclear energy industry over the last 60 years can fit on a football field at a depth of less than 10 yards. Although the United States does not currently recycle or reprocess nuclear waste, some advanced reactor designs being developed can operate using used fuel. The NICE Future Initiative, a global effort under the Clean Energy Ministerial, ensures nuclear energy is considered in developing advanced clean energy systems for the future.
An efficient energy source is what PoW cryptocurrency requires, and given what PoW crypto like Bitcoin has to offer, the initial investment into transitioning from polluting and inefficient energy sources seems completely worth it.
Proof of Work has been successfully used in the Bitcoin network for over a decade, having demonstrated its effectiveness in securing the network against attacks and maintaining the integrity of the ledger. As a monetary policy alternative, PoW offers decentralization and security. Centralized Proof of Stake et al. just cannot compete.
Having clarified that the only ‘valid’ criticism of PoW cryptocurrency is its impact on the environment — a drawback not inherent to crypto and currently being rectified — there seem to be no doubts left. If you wish to have authority over your own earnings and savings, without having to negotiate with third parties or cut down trees to have your bank notes printed: PoW cryptocurrency is the way to go. All you have to do is remember your keys.