Proof in Crypto
After a fair bit of market speculation by myself, I felt the time was right to bring it back to the nuts and bolts of blockchain. Recently crypto markets have been doing well, despite looming regulation and outright bans in the US and China respectively, so they have gained another wave of attention from newcomers to the industry.
We will be dealing with some of the functional aspects of the technology that is blockchain which powers cryptocurrencies, so if you're unfamiliar, or need a refresher, I strongly recommend you read my previous article on the matter: What Actually is Blockchain?
In that article, I explain the function of a distributed ledger system which sends the key information of a proposed transaction to the users in the network, who then work to identify whether it is authentic and correct. After the users on the network reach a consensus, the process is complete. This system is called 'Proof of Work' and the participants are referred to as 'miners'.
There are two big problems with this system. The first being that it is a system where miners compete with each other to approve transactions, leading to a lot of wasted energy, and by extension energy costs and emissions. The second problem is the equality of this system. Someone with major wealth inherently has the advantage as they can expand their mining capabilities more than the regular person, as they're able to withstand the immediate, and ongoing costs that would result in. While there isn't anything wrong with this, it opens up the entire system to a '51% attack', where control of over 51% of the consensus operators by a single entity can allow for fraud.
A new system, called Proof of Stake, has been offered as a solution to this. 'Staking' is the process by which you offer up collateral of a particular currency in order to volunteer for the validation of these transactions that need to be processed. Instead of actively competing against other users, an algorithm designed by the developers choose who the validators are. The more collateral you put in, the greater your chances are. As a result of successfully validating transactions, this collateral is returned to you, and as reward for your services, you are rewarded with 'interest' on your deposit in effect.
This is shown to have greatly increased the energy efficiency of the system, as well as making it significantly harder for one entity to control 51% of the validation process as a result of the increase in decentralisation. So it's easy to see way there has been such a big shift towards this new way of validating transactions, but there are new challenges that it gives rise to.
The first one is initial distribution. It's impossible to stake when there are no coins in circulation, right? What has been the most common plan of attack is to start with a mining system initially, and than to facilitate the transfer to a staking system.
One of the other challenges is monopolisation. Someone validates most of the transactions, they are rewarded with the majority of future coins. There is major variance to the response to this issue so it would be hard to go through them all, but one of the first responses was the idea of 'coin age'. The older the coin that is staked the less likely it is to be chosen to validate a transaction, although I don't like the fact that it punishes coin holders for no reason and could harm smaller coin holders.
Takeaways
Proof of Work systems have problems around energy cost and security the Proof of Stake can remedy
Instituting Proof of Stake gives rise to another range of challenges to face around incentive structures
There has been a gradual shift towards Proof of Stake in the last few years
Coming Soon...
The Future of Central Banking
Exploring Crypto World #5