Proof-of-Work vs. Proof-of-Stake

There are currently discussions about Ethereum switching from Proof of Work to Proof of Stake. This change could affect the overall market related to crypto mining. This is an important risk factor that you, as an investor, should know.

Proof of Work

Proof-of-Work (PoW) happens when a miner solves an exceptionally difficult math problem and gets credit for adding a verified block to the blockchain. Finding a solution is an arduous guessing game that takes a considerable amount of computing power to compete for the correct answer. Once the computer guesses the answer it then sends a message to the other computers in the community for verification. The solution is easy to verify because the other computers are given the answer. Imagine being handed a ring with several million numbered keys on it and you’re racing to find the one that fits the keyhole first. Everyone keeps trying keys until one fits. The person who finds the key first then yells out to everyone….”hey, it’s key number 23,458”. Everyone in the community pulls out key number 23,458 and verifies that …yes…indeed….that key does fit the keyhole. The person who found the key first is paid the prize. Then everyone is handed another ring with another several million keys on it …..and the guessing game begins again.

Unfortunately, while mining offers real world solutions it also uses a large amount of real world resources. Mining requires ongoing purchasing of hardware and an immense amount of electricity. These two issues are troublesome to people concerned about the planet and its environment. It takes a lot of power to run the computers, or clusters of computers, that calculate different potential solutions. And the constant turnover of equipment creates a massive stockyard of obsolete parts. From an ecological standpoint, this isn’t ideal.

Additionally, the fact that you need a serious amount of computing power, more than the average person can afford, means the mining community is getting smaller and more exclusive. This goes against the idea of decentralization and can create the risk of a take-over by someone who controls more than 51% of the network’s computational power. Given the enormous cost — some believe in the billions, we consider this to be a lower risk factor.

ASIC Miner deployed in one of HydroMiner’s hydro plants

Proof of Stake

Proof of Stake (PoS) happens when a miner puts up a stake, or locks up an amount of coins, to verify a block of transactions. The cryptographic calculations in PoS are much simpler for computers to solve. You only need to prove you own a certain percentage of all coins available in a given currency. For example, if someone owned 2% of all Ether (ETH), they’d be able to mine 2% of all transactions across Ethereum. Some believe that PoS would be a more fair system than PoW, as technically anyone could become a miner. PoS offers a linear scale regarding the percentage of blocks a miner can confirm based on that person’s stake in the cryptocurrency. That means someone with ten times more coins (e.g. $10,000 vs. $1,000) you could only mine ten times more blocks.

Some believe that switching to PoS could help to encourage more community participation, as well as aid decentralization. Taking mining out of the hands of the few pools of GPU farms, would distribute the work evenly across the network, leading to a more democratized system.

Other Consensus Models

There are other consensus algorithms coming onto the market as well. For example, Proof of Space proportions voting power based on how much data storage space a node has. There’s also PoET (proof of elapsed time) and a whole host of other “proofs-of” algorithms, most of which are still unproven. It’s fair to say, however, that technology continues to develop exponentially and there’s no way to know what might come along and disrupt the crypto community, either partially or entirely. We do feel, nevertheless, that Hydrominer is structured in a way that we can be fluid and flexible when new ideas and technology come along. With multiple lines of businesses and services, we can move agilely between departments as needed for revenue production.

Why We See Proof of Work Continuing to Grow and Be Viable

While PoS definitely has its place, we believe that there will be an ongoing need and desire for PoW.

PoW provides benefits to clients and the industry that PoS doesn’t.

• Supply Distribution Proof of work is better for supply distribution of a currency. Although the miners are being paid for their work, the cost associated with validation typically requires them to sell their supply of coins rather than holding them. This creates more even distribution and liquidity to the market. Hoarding is not beneficial to a miner like it is to a staker, so there is a greater reward for buying and selling rather than holding.
• Consensus and SPV Clients In a proof of work system, if the chain gets forked into two chains due to social or technical consensus issues, it is easier to determine which chain has better mining support. Clients will typically follow the chain with most work done. This creates a stronger blockchain with less likelihood of double payment or validation.
• Inflation control Proof of work algorithm is better for containing inflating currencies because it can change the difficulty of the equation to adjust the printing of new coins. With Proof of Stake coins, no cooperation between the technology and markets exists to regulate and maintain a deflationary supply. Mining is determined by balances in the wallets of coin holders. Blocks are produced on a set schedule and the distribution of new coins is determined proportionately based on how many unspent coins staking wallets possess. Essentially, Proof of Stake, removes the cost of mining entirely, leaving no room for a market mechanism to emerge and regulate inflation. Theoretically, then, the growth in supply of PoS coins remains constant, regardless of its value and staking profitability. This completely destroys any market-sourced monetary rules that keep supply in check. As a result, even with a total supply cap, supply shocks will plague a PoS-based monetary system, leaving no room for stability and making it hard to have reliable economic growth.
• Equipment Quality Under PoW protocols, miners are constantly upgrading their hardware and looking for less energy intensive solutions. Utilizing better equipment often functions exponentially better than less expensive counterparts of PoS.
• Incentives Align With the Community PoW encourages the major forces within the ecosystem to work for the betterment of the community by incentivizing investment into the system — miners who allocate more processing power for the blockchain earn more in return. Above all else, it incentivizes honesty because ensuring the integrity of transactions also ensures a miner’s rewards. Additionally, as more miners come into play and better processing equipment is introduced, It’s in a miner’s best interests to invest more to compete for the rewards. While they still earn fees from every transaction they process, they also need to compete for a portion of the network in order to get a higher chance at mining Bitcoins. Consequently, it also becomes significantly harder to gain enough hash rate (51%) to attack the system — it gets too expensive to do so, and offers very little reward especially compared to mining. Today, it is estimated that it would cost over a billion dollars in mining rigs alone to pull this off.
• Security A pure PoS approach poses higher security threats that are not inherent in a PoW system. PoS consensus is not anchored in the physical world (with hashing equipment in PoW). Most currencies relying on PoS also use additional mechanisms to address security issues, often this is a combination of both PoS and PoW.
• Forking and Double Payment The proof of stake algorithm has a serious problem: if there is a fork of the blockchain (whether accidental or deliberate), the rational behavior for all users of the network is to mint blocks on both branches. With a PoW algorithm, such behavior is irrational. By splitting the resources on multiple branches, a miner diminishes the probability of finding a block. The optimal strategy in a PoW system is always to mine on a single branch were as the rational behavior in a PoS system is to mint blocks on top of all branches that a user is aware of. This problem makes it easy to perform double-spending or other sorts of attacks that come with forking the blockchain.
• The Rich get Richer Unlike PoW where the miner gets paid for doing the work, in a PoS world, the more you own, the more you mine, the more money you earn. Additionally, under this algorithm, changes to protocol code is not determined by miner consensus, but by a vote from staking wallets. The protocol weighs votes based on the holdings of staking wallets. So whoever has the most money has the most influence over a vote. This means that a small group of wealthy stakers can control the entire network, voting on changes that benefit them — even at the cost of the rest of the network. Under such a system, a large entity or wealthy group, such as a central bank, can use fiat money to purchase vast quantities of a PoS coin, hold them until their wallets become eligible for staking, and then take over the network. Once the network has been infiltrated and seized by these interests, they can do things that make the PoS system less efficient and more dangerous than it already is. For example, controlling interests in a PoS network could vote to remove the supply cap. And since they have the highest holdings of staking coins, they get the highest cut of the new coins — giving them majority control over the monetary supply. Such a vote would essentially create a central bank, allowing controlling stakers to use and distribute newly-minted coins as they please. In other words, they can conduct central banking monetary policy. Consequently, economic cycles, politics, and corruption will enter the equation, throwing the PoS-based economy into chaos.
• Voter Apathy Under delegated PoS one of the major challenges is voter apathy. Many people vote once and then forget to change their vote or they vote for a proxy and then forget to follow up. The usual end result is that it becomes difficult to vote out incumbents or vote in new individuals. The presence of voter apathy is a sign that incentives are not properly aligned in the system. This is where migrating from delegated-proof-of-stake to a delegated-proof-of-work system has some serious benefits. When power is in the hands of users who have a long-term capital commitment to a project they have greater incentive to vote because they cannot sell for months or years. Under the existing delegated-proof-of-stake system most users opt to passively accept the decisions made by others and then vote by selling the token if they don’t like the result. When users have the ability to “vote without commitment” the whole community plays a heads-I-win, tails-you-lose game. This means losing the minority who disengage in the process, which then undermines the value of the token.
• Hoarding POS encourages hoarding, which is great for speculation but not for a currency or its liquidity. Because PoS rewards people for the number of coins they have, the natural thing would be to hold the coins rather than redistribute them. This means that liquidity would dry up and the whales, having the most tokens, would control the validation process. This defeats the entire basis of a decentralized system and removes the most important part of blockchain — the arm’s length transaction and trust factors.
• Staker vs Community Staking votes are often not representative of the blockchain community they’re a part of. For instance: if there are 500 coins in circulation, but only 50 coins participated in staking, an attacker would only need 51 staked coins to change protocol. Now imagine what would happen if there were only 2 staked coins. Until there’s a practice that ensures that all authorized coin owners stake their share, there’s always the risk of a takeover or a decision where a stakers interests do not align with the communities.

The reality is that while Proof of Stake does manage some of the problems posed by the Proof of Work mechanism, it creates several new completely different problems. In the world of cryptocurrencies, proof of work is the most common protocol. In the Bitcoin world, proof-of-work is the only protocol. In the PoS world, most cryptocurrencies currently use a combination of both. Understanding the reasons behind this gives us confidence in our premise that PoW will continue to be a driving force in the blockchain community. Additionally, Hydrominer is directly attacking the main issues surrounding mining. By decreasing the carbon footprint and utilizing alternative energy sources, the Company is able to justify the mining resources. Furthermore, the company has a hardware resale program in which older equipment is sold to smaller mining operations or companies wanting to self-mine. Both of these strategies directly attack the biggest concerns surrounding PoW and position Hydrominer to be the leader in alternative energy mining.

Written by Kellee Bergendahl, Managing Director at Ascendiant Capital Markets LLC. She is Co-Manager of tZero’s capital raise, the most important Security Token in the USA and is financial advisor to HydroMiner.