When it comes to valuing crypto assets, it’s easy to get caught up in traditional statistics like market cap, trade volume, or liquidity. But unlike traditional commodities, stocks, or even fiat currency, crypto asset valuation requires a unique lens - a lens that must factor in an element most other assets are not subject to: the underlying fundamental technology that drives its existence.
So, what are these technology factors that make various cryptocurrencies unique and distinguishable from one another? And why are they important?
Over the course of this 2-part series, these are precisely the questions we set out to answer. Particularly, we’ll delve into centralized vs. distributed ledgers and the concept of ‘Consensus Mechanisms’ - specifically the two largest and most utilized forms: Proof-of-Work (PoW) and Proof-of-Stake (PoS).
The core difference in their operation is actually quite straightforward. Used to validate transactions, PoW requires computers to solve complicated equations (ie mining), while PoS requires owners of cryptocurrency to ‘stake’ their coins for the same validation. These structural elements of a cryptocurrency’s blockchain are the backbone of trust in its ecosystem and potential growth.
Part of understanding how these consensus mechanisms work involves understanding their predecessors. For centuries, accounting ledgers have been the bedrock of commerce by enabling transactions to transcend the traditional limitations of P2P trust.
When an individual buys a product or receives fiat currency for a service delivered, traditional third-party intermediaries are used to facilitate the transaction. These mediators hold private ledgers/records of the history and balances of each account they maintain. They then use those records to verify transactions as true and allow business to take place between strangers.
Examples of third-party mediators include:
Their centralized nature however leaves them vulnerable to manipulation, data leaks, and more recently of course cyber-attacks. Further, their facilitation is funded by consumers who pay premiums in fees collected by these centralized intermediaries.
The distributed ledger, the core tech behind blockchain, does not suffer from the same shortcomings – at least not remotely to the extent its centralized predecessors do. Key to their operation is the collective agreement across their network of the state of the ledger and its contents, verifying that information added to the ledger is true. This is known as the consensus. This verification ensures new blocks that are added represent the most current transactions on the network, preventing double spending and other ‘impossible events.’
There have been a number of consensus mechanisms proposed to operate distributed ledgers and new, innovative and/or hybrid solutions are continually being introduced. Below, we’ll discuss how Proof-of-Work functions in practice, how mining drives the PoW ecosystem, as well as its impact on the crypto market.
Proof-of-Work (PoW) Explained
The idea behind PoW existed long before cryptocurrencies and was first mentioned by Dr. Markus Jakobsson in a 1999 research paper. In 2008 Satoshi Nakamoto popularized the idea by using it to underpin the Bitcoin Whitepaper - envisioning a currency that would rely on a trust-less and distributed consensus system unlike any in existence.
In the paper, Nakamoto proposed that the use of a PoW system ensures security and immutability across transactions by preventing any one entity from gaining control over a network. The only way control can be gained is through the near impossibility of a 51% attack. SN’s unique application of PoW was a catalyst for the entire cryptocurrency market and it continues to power some of the most popular crypto assets today.
Unlike the centralized intermediaries mentioned above, Bitcoin and other PoW based cryptocurrencies allow for peer-to-peer exchange without the need for a third-party mediator. Instead, mediators are replaced by ‘miners’ who work on behalf of cryptocurrency holders to see that transactions are successfully processed:
- A group of transactions that require verification are bundled into a block.
- Miners then verify that each of these transactions are true by using computing power to solve cryptographic puzzles. These miners are all in competition with one another.
- The first miner to solve these puzzles is rewarded with newly minted cryptocurrency and the network transaction fees.
- This, now verified, block is added to the blockchain.
In addition to Bitcoin, some cryptocurrencies that use Proof-of-Work to secure their networks include:
- Ethereum (now a hybrid of PoW and PoS)
While it may have been a catalyst for the market growth, the future may be less certain for PoW. Since transactions are dictated by competition and computational output, we’re beginning to see major scalability issues:
- As more transactions and users are added to a currency’s network, more computing power is needed
- As more computing power is added to the network, the hash rate increases in difficulty
- A more difficult hash rate requires more computing power to solve.
- This leads to a vicious cycle of escalating requirements of computing power and with it escalating energy consumption.
This self-defeating cycle is the reason, for example, that the Bitcoin network is projected to soon consume 0.5% of the world’s electricity. Conversely in 2012, individuals could mine a Bitcoin with a laptop – today the equivalent requires multiple purpose-built ASIC (Application Specific Integrated Circuit) miners: a tenfold increase in cost, computational power, and energy needs.
Companies like Bitmain (recently valued at $12B USD) have made big business of creating these ASIC miners to solve crypto algorithms up to 10,000x faster than even the best CPUs. GPU mining rigs have also entered the fray and outcompete both ASIC and CPU miners in some instances.
If you're making an investment decision on a coin that relies on PoW, you’d be wise to consider the ramifications of its mining approaches as summarized below:
In the context of cryptocurrency, an ASIC miner is made up of a microchip that is purpose-built to execute a particular hashing algorithm in as little time as possible. Because ASIC miners are custom built for a particular algorithm, different ASICs are required for different coins. This custom nature also makes them the most powerful miners on the market. However many criticize ASIC miners for their move towards mining power consolidation and centralization. Coins that rely on PoW require decentralization to protect against a 51% attack on the network.
Their development has led to an arms race of sorts, with some coins now developing algorithms that are ‘ASIC resistant.’ Additionally, some such as Bitcoin Gold and Vertecoin have promised to hard-fork to different hashing algorithms if ASICS are developed for them. Ethereum is the largest cryptocurrency that is ASIC resistant. Ethereum’s move towards a hybrid system of PoW and Proof-of-Stake (PoS) has likely further deterred the development of ASIC miners.
While not as powerful as ASIC miners, GPU (Graphical Processing Unit) miners are more flexible in their application. A GPU is the chip on a graphics card that does repetitive tasks, such as render detailed, high res graphics. Unlike ASICs, it is possible to mine multiple coins using the same GPU.
Central Processing Unit (CPU) powered miners are rarely discussed as their make-up is not conducive to mining. PoW rewards repetitive mathematical calculations, making CPUs ill-suited to compete against ASIC or GPU rigs. However, CPUs are theoretically best suited to uphold the decentralization of cryptocurrencies: If you have a computer, you have CPU.
Part 2 of 2
In our next post, we’ll continue the discussion with the shift towards Proof-of-Stake, along with its fundamental differences from Proof-of-Work in both the short and long term. We’ll also walk you through one of the most noteworthy happenings in the commercial evolution of blockchain consensus mechanisms: Ethereum’s plan to shift from PoS to PoW and it’s current hybrid transition called Casper. Finally, we’ll touch on new ‘Proof-of’ mechanisms recently introduced and what the future may hold for them.