For all participants to behave correctly in a decentralised system, economic incentives must be designed to avoid the misconduct of individual actors. Blockchain technology enables individuals and organisations around the world to work together in a network using a jointly managed list of transactions. To ensure that network participants are acting honestly, transactions are validated and verified collaboratively (Voshmgir & Kalinov, 2018). In this process, various consensus mechanisms use incentives to ensure that each participant behaves in the best interests of the network. This creates a secure, fault-tolerant and neutral system in which cheating others is not worthwhile. How consensus mechanisms work and what economic incentives are applied is discussed below.
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A consensus mechanism is a protocol that ensures in a blockchain that all network nodes are synchronized with each other. The protocol defines the rules according to which the network nodes agree on the transactions that are legitimate to be added to the blockchain. The most widespread consensus mechanisms are the Proof-of-Work (PoW) and Proof-of-Stake(PoS) consensus.
Proof-of-Work (PoW) was the first consensus algorithm of a blockchain. Satoshi Nakamoto (2008) adopted the PoW algorithm from Back (2002) for the use in the Bitcoin blockchain. The PoW algorithm is not only the reason for the high security of transactions in the Bitcoin network, but also for the mining activities and the associated power consumption. PoW is a very reliable but rather inefficient method of validating transactions for a large number of network nodes. Due to these inefficiencies, researchers are currently working on different possibilities to reach tamper-proof consensus in a decentralized system. One example is the Ethereum project. By switching from PoW to PoS, the scalability and efficiency of the smart contract platform is to be increased (Whiterspoon, 2018).
How does the PoW work?
In PoW, so-called miners solve complex mathematical tasks that require a lot of computing power. The first one to solve the task creates a block of transactions and receives a reward in return. The more computing power a miner applies, the greater the probability that this miner can create a block. (Blockgenic, 2018)
All miners work simultaneously on the same task and compete with each other to find a correct solution. If one of the miners finds a solution, it is shared with the entire network and a new block of transactions is created. The other miners check the result and the one who solved the block is rewarded. The Miner has proven that he has spent computing power to solve the task and thus to create the block — this is where the term “proof of work” originates. Miners now try to solve the next block of transactions, which is based on the previous one. The blocks are concatenated in chronological order, which is why we speak of a chain of blocks — the blockchain.
By linking the blocks it is ensured that manipulating transactions is economically not worthwhile. Miners always trust the longest blockchain, as this is where the most computing work has been done. Data manipulation is therefore extremely costly and can only be accomplished with more than 50 percent of the computing power of the whole network. Strongly decentralized PoW blockchains with a large number of miners can thus hardly be manipulated.
In contrast to PoW, in a PoS system the participants with the highest net worth in the network have an interest in maintaining the network. Validators of transactions are randomly selected to create blocks of transactions, taking into account the amount of assets involved. If the transactions are validated correctly, they are subsequently remunerated for their efforts. (Blockgenic, 2018)
The validation in PoS is not carried out via the use of computing power. Instead, validators bet their assets (stake) in the form of tokens on the accuracy of transactions. In case of discrepancies, the validators use their tokens to vote on which version they want to support. Participants who vote for the wrong blocks lose their stake. PoS therefore creates an incentive for network participants to behave correctly in a new way (Whiterspoon, 2018).
How does the PoS work?
Deposit: In PoS, block creators are called validators. Validators must make a deposit (stack) to participate in the block creation.
Selection: While in PoW the validators are in competition with each other, the selection of validators in PoS is based on a pseudo-random function taking into account the stake made by each validator.
Scalability: In contrast to PoW, PoS reduces energy consumption as only one validator validates transactions at a time and almost no computing power is required.
Incentives: Incentives to behave correctly are generated through the use of assets and the corresponding reward or punishment.
Security: If validators validate incorrect transactions, they lose their investment. Since this stake is higher than the reward for correct validation, there is a great incentive for the validators to behave in the best interests of the network.
Other consensus mechanisms
In addition to PoW and PoS, in practice there are numerous other consensus mechanisms such as:
- Proof-of-work (Bitcoin, Ethereum, Ethereum Classic, Litecoin, …)
- Proof-of-stake (Ethereum 2.0, Dash, Enigma, …)
- Delegated Proof-of-Stake (EOS, Lisk, Nano, …)
- Proof of capacity (Siacoin, Storj)
- Byzantine fault tolerance (Hyperledger)
- Proof of authority (VeChain, Corda)
According to a study by Hays (2018), among the top 100 cryptocurrencies, PoW and PoS or a hybrid solution of both mechanisms are the most widespread. The most common alternatives are briefly explained below.
Delegated Proof-of-Stake (DPoS)
In DPoS, token holders do not vote themselves on the validity of the blocks, but elect representatives to perform the validation on their behalf. Usually there are between 21–100 elected representatives in a DPoS system. The delegates are regularly mixed and are instructed to submit their blocks. (Whiterspoon, 2018)
Proof of Authority (PoA)
Proof-of-authority is a consensus method in which transactions are validated by approved users — similar to a system administrator. These users are the instance from which other nodes obtain their truth. PoA has a high transaction throughput and is optimized for private networks. PoA is usually not used in a public blockchain because it is a rather centralised solution. (Whiterspoon, 2018)
Byzantine Fault Tolerance (BFT)
Byzantine Fault Tolerance (BFT) is the property of a system that is able to function even if some of the nodes fail or act maliciously. In other words, the majority of nodes within a distributed network must agree to avoid a total failure. For this to happen, at least two-thirds of the network nodes must behave honestly. If the majority of the network decides to act maliciously, the system is vulnerable. (Binance, 2019)
Proof of Capacity (PoC)
With PoC, similar to PoW, solutions are sought for the concatenation of transaction blocks. Instead of using computing power to compute cryptographic problems, possible solutions are stored in advance on digital data storage devices (e.g. hard disks or servers). After a memory has been plotted — i.e. filled with solutions — it can participate in the process of block creation. The block validation is done by searching for ready-made solutions that are located on the data storage devices. Validators with a higher memory capacity are more likely to find a block because they can search through more solutions. (Binance, 2019)
Back, A. (2002). Hashcash — A Denial of Service Counter-Measure. Retrieved from http://www.Hashcash.Org/Papers/Hashcash.Pdf.
Binance. (2019, Dezember 30). Byzantinische Fehlertoleranz. Retrieved January 2, 2020 from https://www.binance.vision/de/blockchain/byzantine-fault-tolerance-explained
Blockgenic. (2018, November 10). Different Blockchain Consensus Mechanisms. Retrieved from https://hackernoon.com/different-blockchain-consensus-mechanisms-d19ea6c3bcd6
Hays, D. (2020, Februar 13). Consensus Mechanisms. Retrieved from https://cryptoresearch.report/crypto-research/consensus-mechanisms/
Nakamoto, S. (2008). Bitcoin: A Peer-to-Peer Electronic Cash System. Abgerufen von https://bitcoin.org/bitcoin.pdf
Witherspoon, Z. (2018, Juli 19). A Hitchhiker’s Guide to Consensus Algorithms [Blogpost]. Retrieved January 2, 2020, from https://medium.com/hackernoon/a-hitchhikers-guide-to-consensus-algorithms-d81aae3eb0e3
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