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Understanding DeFi: Proof-of-Work and Proof-of-Stake Explained

Blockchains are globally distributed systems. As they are not controlled by any single party, the nodes on each network have to find a way to agree on what the accurate record of data for the blockchain should be. To achieve this, they rely on cryptographic consensus mechanisms. The earliest example of a consensus mechanism for a blockchain was Proof-of-Work, introduced by Satoshi Nakamoto for Bitcoin. Ethereum also launched with a Proof-of-Work consensus mechanism, but it will soon be migrating to another type of mechanism called Proof-of-Stake. In this guide, we’ll explain how they both work, as well as the benefits and drawbacks of each.

Disclaimer: We want to highlight that this article does not constitute financial advice. The information presented is for educational purposes only. Investing in cryptoassets is risky and does not guarantee a return. Monolith takes no responsibility for the stability of any blockchain protocol.

Proof-of-Work explained

Proof-of-Work is a type of cryptographic proof used to prove that a miner has completed a certain amount of computational work.

It was first introduced with the Bitcoin blockchain to achieve consensus on the network. Ethereum also currently uses Proof-of-Work. It secures the blockchain by ensuring that nodes come to an agreement on every transaction on the network.

It’s particularly important for preventing “double spending”. If Bitcoin users could spend their coins more than once, the supply would inflate above 21 million and the asset would be debased and lose its value.

A “blockchain” is essentially an open ledger that contains the full transaction history of the network. New transactions get added in blocks.

In Bitcoin’s case, miners add new blocks to the chain through Proof-of-Work. The “work” refers to mining.

Miners race to complete complex computational problems and earn rewards in exchange for their work. Bitcoin miners race to find a 64-digit hexadecimal number called a “hash” equal to or below a “target hash”. These problems are extremely difficult to solve, and each block has a difficulty level. At publication, the difficulty level is 14 trillion, meaning the chance of coming up with a hash below the target on the first attempt is 1 in 14 trillion.

Miners come up with new hash possibilities at lightning speed, which requires vast amounts of energy and expensive hardware. It takes a miner roughly 10 minutes to find the target hash.

Bitcoin miners earn a block reward, as well as any transaction fee. This incentivises them to commit new blocks to the main chain. Proof-of-Work ensures that the chain gets extended, and it’s very difficult to attack.

A malicious attack on the Bitcoin blockchain would require 51% of the network’s hashrate, which is difficult to obtain due to the number of miners contributing to the network today.

It’s worth noting that blocks can occasionally be mined simultaneously, which leads to a temporary fork of the chain. The main chain then becomes accepted when a new block gets mined. This is when a transaction hits “finality” and cannot be reversed.

Advantages and Disadvantages of Proof-of-Work

Proof-of-Work has many advantages. Unlike with Proof-of-Stake, anyone can add new blocks to the chain without holding the underlying asset. For this reason, some Bitcoiners argue that it is a better system of coin distribution than Proof-of-Stake. The mechanism also has something of a Lindy effect — it’s successfully secured Bitcoin since 2009 and Ethereum since 2015.

However, it’s hard to overlook Proof-of-Work’s flaws. The most common criticism of Proof-of-Work is its staggering energy usage. Vast amounts of power are required to run the mining rigs completing the complex computational problems. According to data from Cambridge University, Bitcoin currently uses about as much energy as Chile.

In 2021, Elon Musk spoke out against Bitcoin’s energy usage when he confirmed that Tesla would stop accepting Bitcoin payments until mining became more sustainable. The move sparked debates surrounding Bitcoin’s environmental impact and arguably helped the asset tumble in value. Although many Bitcoin miners are turning to renewable energy sources, the network is a long way off achieving carbon neutrality.

Moreover, as mining requires sophisticated equipment, it can potentially lead to centralization due to large mining pools controlling significant amounts of the hashrate. Mining equipment also has a high start-up cost, which excludes many people from getting started.

Proof-of-Stake explained

Proof-of-Stake is a consensus mechanism that has gained popularity in recent years. It’s used by many newer cryptocurrencies.

Ethereum is planning to “Merge” from Proof-of-Work to Proof-of-Stake as part of its forthcoming development roadmap. The update is called The Merge as the new Beacon Chain (otherwise known as the consensus layer) will “Merge” with the current Ethereum chain (otherwise known as the execution layer). It’s expected that Ethereum will complete The Merge sometime in 2022.

Like Proof-of-Work, Proof-of-Stake aims to achieve consensus on the network. However, it has some major differences.

With Ethereum’s move to Proof-of-Stake, it will rely on validators staking ETH on the network rather than miners contributing computational power.

Becoming a validator on Ethereum requires depositing 32 ETH to a staking contract on the Ethereum Beacon Chain, though there are staking pools that allow users to secure the network by depositing a smaller amount of ETH.

Staking incentivises users to be reliable validators. If a validator goes offline when they should be adding a block to the chain, a small amount of their stake will be slashed. If they maliciously collude against the network, meanwhile, they face losing their entire stake.

With Proof-of-Stake, instead of competing to commit new blocks to the chain, validators are randomly selected by an algorithm. This also means that they don’t require huge amounts of computational power.

Ethereum 2.0 will see the network add 64 shard chains to the Beacon chain. Validators will have a duty to add transactions to shard blocks. 128 other validators will also have to attest each shard block as part of a “committee”.

The committee will have a time “slot” to validate shard blocks, which each feature one block. There’ll be 32 slots created per “epoch”, after which a new group of validators will form a new committee.

When a new shard block has a sufficient number of attestations, a “crosslink” will confirm the block and the transaction in the Beacon chain. At this point, the validator will receive the block reward. Ethereum’s current block reward is 2 ETH.

Finality is achieved when ⅔ of validators agree on a block’s state at a given checkpoint via the Casper finality protocol.

While a 51% attack is possible with Proof-of-Stake, it requires 51% of the staked ETH rather than the mining hashrate required in Proof-of-Work. This means that Ethereum becomes more secure as more ETH is staked. The network currently contains over 12.8 million ETH worth over $24 billion, so there would be a huge expense to attacking the network. It’s likely that the value would drop in the event of a 51% attack, meaning there is little incentive for an attacker holding a significant amount of the staked asset.

Advantages and Disadvantages of Proof-of-Stake

Proof-of-Stake has many advantages over Proof-of-Work. It has a lower startup cost to secure the network, as it’s easy to run a node with relatively affordable hardware. For this reason, it allows for participation from a broader user base than mining, improving decentralisation. In Ethereum’s case, staking also creates a way to have secure sharding, which makes the network more scalable. Another major advantage of Proof-of-Stake is the energy efficiency it offers over Proof-of-Work. It’s estimated that Ethereum will become 99.95% more efficient when it moves to Proof-of-Stake.

However, there are some disadvantages to Proof-of-Stake. Some blockchains require large amounts of the network’s reserve asset to become a validator. Critics have pointed out that Ethereum requires 32 ETH, which is a $60,000 outlay at today’s prices, and therefore excludes many participants. However, staking pools make it possible to help secure the network with a much smaller investment.

Proof-of-Stake is also less battle tested than Proof-of-Work. Bitcoin’s consensus mechanism has secured the network since 2009, whereas Proof-of-Stake is a much more recent innovation in cryptocurrencies.

Final notes

In conclusion, Proof-of-Work and Proof-of-Stake are useful mechanisms for helping blockchains achieve consensus. While there are clear benefits and drawbacks to both mechanisms, the industry has started to embrace Proof-of-Stake in recent years. A big factor behind this move is the energy efficiency Proof-of-Stake offers over Proof-of-Work. It remains to be seen whether Bitcoin will achieve sustainable mining. Now that you’ve learned about both consensus mechanisms, what do you think about Ethereum’s move to Proof-of-Stake?

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