Team Luno
Team Luno
Apr 16 · 6 min read

On the island of Yap in the Pacific Ocean, people use heavy stone discs up to 4m in diameter as money. So, a little less practical than, say, a bank note. Known as Rai stones, their value is contingent on the effort required to make them in the first place. Islanders had to travel hundreds of miles by sea to quarry and transport the stones from other islands, an extremely dangerous voyage where lives were often lost. The difficulty of obtaining Rai stones keeps them scarce and therefore valuable.

A similar idea is behind the value of cryptocurrencies, known as proof-of-work, that can be otherwise understood as a protocol or verifying mechanism for transactions in the case of Bitcoin. Today, we’re taking a look at what proof-of-work is, how it differs from proof-of-stake, and why it’s necessary to keep the Bitcoin network running.

Photo by Roman Mager on Unsplash

What is proof-of-work?

POW (Proof-of-work) is the protocol the Bitcoin network uses. It involves data that requires a lot of resources to produce and must meet certain verifiable requirements.

It’s generally based on finding a solution to a problem through trial and error. Although producing proof-of-work is difficult, verifying it is simple.

Bitcoin uses a proof-of-work function called SHA256, which was first designed for preventing spam emails from making their way into people’s inboxes. This essentially requires miners (computers that run the network and ‘mine’ new Bitcoin) to solve computational puzzles, each with a different solution. You could imagine this as being a bit like lots of people trying to solve a sudoku puzzle with a prize for the first to complete it.

Doing so takes up a lot of computing resources and requires expensive equipment. When a miner receives new Bitcoin, they’ve proven that they’ve invested resources into it, so they’re not just producing it out of thin air. Think back to Yap and how those creating the heavy stone disks worked tirelessly to do so. One of the big misconceptions about Bitcoin is that because it’s digital it costs nothing to produce. In fact, there’s no way to produce it without solving a block. This system basically ensures that miners are eating their veggies before they get dessert.

Even though mining Bitcoin doesn’t necessitate lugging heavy stones across hundreds of miles in a tiny boat, it does have a cost. However, the two systems are more similar than it might seem — both Bitcoin and Rai stones require real, tangible resources to produce.

The new Bitcoin compensates miners for their efforts because they’re needed to run the network. Proof-of-work is one of the genius details of the Bitcoin network.

It provides economic incentives for miners, justifying the risk they take on by investing in equipment. The random nature of proof-of-work also means that new Bitcoin is randomly distributed between different people. This system is effectively egalitarian because any miner can solve a block, meaning no one person or group can take control of newly released Bitcoin. However, a miner’s chance of solving a block depends on how much computing power they have.

By contrast, the value of local currencies isn’t connected to how much they cost to make. A $100 bill costs about 13 cents to make, but a 1 cent coin costs more than 1 cent to make.

Why is proof-of-work needed?

These aren’t the only consensus mechanisms out there. Some cryptocurrencies use others, such as delegated proof-of-stake, proof-of-authority, and proof-of-weight (we’ll get into some of these a bit later). Each has its own pros and cons, despite having the same purpose: to provide a way to process and verify transactions, while keeping the network secure.

The purpose of proof-of-work is to give miners an incentive to support and secure the Bitcoin network by making it profitable to do so and making it unprofitable to attempt to hack the network.

In the process, proof-of-work helps protect the network from malicious activity, ensuring that miners cannot add fake blocks to the blockchain. If a miner tries to attack the network, they will need to use a lot of expensive resources, but they won’t receive the reward (newly released Bitcoin) that ‘friendly’ miners do. For this reason, it makes more sense to play by the rules.

Alternatives to proof-of-work?

Proof-of-stake is an alternative system, used by a number of altcoins (alternative cryptocurrencies). Now, where proof-of-work is concerned, mining depends on computing resources, whereas with proof-of-stake it depends on how much of a given cryptocurrency a miner owns. So if a miner has 1% of the existing coin, they would be able to mine 1% of the coin released in a new block.

It’s not about how much computing power you have, it’s about how much cryptocurrency you have.

Think about having a stake in a poker game, or in a company — the more ‘stake’ you have, the more power you have to control outcomes. In this case, the outcome is how much cryptocurrency you can mine. Proof-of-stake is believed to reduce the likelihood of attacks on the network because an attacker would need to own a majority of the cryptocurrency, which would be unreasonably expensive. So, it would seem that size doesn’t matter after all…

What is ‘mining difficulty’?

As time passes, computing equipment tends to get cheaper and more powerful. The Bitcoin network launched in 2009 and technology has progressed a lot since then. If you remember buying a computer or phone (read: giant brick-and-battery contraption) back then, or even just a few years ago, it was probably more expensive relative to how much less powerful it was than the one you use today. So, to prevent the cost of mining Bitcoin from dropping too low compared to the price, the ‘mining difficulty’ keeps changing.

Mining difficulty refers to how hard it is to mine new Bitcoin. A new block is released on the blockchain every 10 minutes.

Every 2016 blocks (roughly, two weeks), the difficulty is adjusted to keep the time taken to solve each block consistent. If advances in the computing equipment necessary to run the network reduce the time, the difficulty is increased. If the time taken to solve a block increases for any reason, the difficulty is reduced. The network calculates how much to adjust the difficulty by establishing whether the last 2016 blocks took more or less than two weeks to solve. In the early days, the difficulty was so low that anyone could mine their own Bitcoin on a normal laptop, but that’s no longer feasible.

When the Bitcoin network first launched, miners received 50 Bitcoin per block. This reward halves every 210,000 blocks, which takes around four years.

The total supply is capped at 21 million and no more Bitcoin will be released once it’s all been mined. This will probably happen sometime around the year 2140. It’s not known why Satoshi Nakamoto, the creator or creators of Bitcoin, chose these particular numbers.

The importance of consensus

One of the key drawbacks to the current banking system is the absence of transparency, and we’re not of the belief that how your money is handled or processed should be on a need-to-know basis. In almost every context you can imagine, it’s understandable how and why the notion of consensus makes sense in order for decisions or actions to be made fairly and without malicious or self-serving motives.

In addition to this, proof-of-work is an integral part of Bitcoin. It underpins the value inherent to it.

Bitcoin is so valuable because it’s difficult to produce — once you ease that production in any way, its value will ultimately decrease.

In order for any currency to have value, it needs to have some level of scarcity too.

What are your thoughts on other consensus mechanisms out there? Do you also believe proof-of-work is the most effective way to verify Bitcoin transactions?

Reach out to us in the comments below or on Twitter and let us know what you think.

Luno Publication is a global cryptocurrency company, with over 2 million customers in 40 countries. We make it safe and easy to buy, store and learn about BTC and ETH. We strive to educate, and open the doors for dialogue and discussion on cryptocurrency, fintech, finance, and more.

Team Luno

Written by

Team Luno is a global cryptocurrency company, with over 2 million customers in 40 countries. We make it safe and easy to buy, store and learn about BTC and ETH.

Luno Publication is a global cryptocurrency company, with over 2 million customers in 40 countries. We make it safe and easy to buy, store and learn about BTC and ETH. We strive to educate, and open the doors for dialogue and discussion on cryptocurrency, fintech, finance, and more.

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