Blockchains are often introduced as an alternative financial instrument. However, to achieve the feat of working as a reliable financial network the blockchains need several important components such as smart contracts, nodes, cryptography, virtual machines, and others.
One of the most crucial and defining components of a blockchain is its Consensus model. This article is going to compare two of the most popular consensus mechanism and study their impact on DeFi products.
What is a Consensus Mechanism?
A Consensus Mechanism is also known as a Consensus protocol or algorithm. It is used to verify the authenticity of transactions and warrant the security of the blockchain. Since blockchains are Distributed Ledgers therefore they can store the data on blocks.
However, to ensure that the data is accurate the blockchains need to use a peer-to-peer method using computation power to verify them before adding to the main chain.
In other words, Consensus Mechanisms ensure that all the nodes on a blockchain network agree to a single verified version of transaction history or data logs.
Types of Consensus Mechanisms
There are several types of Consensus Mechanisms and blockchain developers are working on creating new types by adding innovations. Some of its most common variants are given as under:
Proof-of-Work is a type of consensus mechanism where miners set up mining machines and compete with each other. The miner who can solve the cryptographic puzzle first wins the mining rewards.
Proof-of-Stake allows the algorithm to delegate the miners using a randomization protocol. However, this consensus mechanism favors the blockchain with the biggest staked cryptocurrency reserves.
Proof-of-Activity is a hybrid between PoW and PoS. Miners use computing powers to solve the cryptographic puzzle and generate the 64-digital hexadecimal number or hash.
However, once the hash has been created the system switches to the PoS mechanism and selects the validator using a randomization option to sign off the hash and validate a new block.
Proof-of-Authority does not depend on the largest staked cryptocurrency reserves like PoS or Proof-of-Activity. It depends on the previous record and the performance of the validators to select them. It also does not require a massive amount of computation power to operate like PoW.
Proof-of-Burn is a modified form of the PoW consensus model. It requires the miners to earn the right to add and verify a new block by burning an assigned number of tokens. However, using PoB miners can unlock their staked cryptocurrencies at their discretion. It ensures long-time commitment from miners.
Proof-of-Capacity is also known as Proof-of-Space. As visible by name in this model the miners are selected for block verification based on free space available with them for data storage. It is important to note that during plotting miners generate as many hash keys to a cryptographic puzzle. More hard disk space means that a miner has more possible solutions.
Proof-of-Elapsed Time was created by Intel in 2016 based on Guard Extensions Software or SGX. This system assigns different time durations for various nodes. The nodes hibernate for the duration and the first one to wake up with the shortest wait time gets the mining assignment and reward.
Proof-of-History is specific to the Solana blockchain. It depends on timestamps built into the blockchain that automatically verify transactions without relying on nodes.
Proof-of-Importance is a consensus mechanism that utilizes harvesting criteria. It uses common factors such as staked crypto amount, network activity, size of the transaction during the last 30 days, and total quantity of transactions in the same duration.
All these factors are used as a criterion to generate an importance score for nodes. The higher the importance scores the better chances for a node to get selected as a validator.
What is Proof-of-Work?
The term Proof-of-Work was created as early as 1990. However, Bitcoin pseudonymous inventor Satoshi Nakamoto adopted this system for the first blockchain project. The PoW mechanism requires miners to compete with each other which means that they earn the mining rewards based on their “work”.
In the PoW model miners set up computing machines or mining farms that try to create as high computation power as possible.
The ultimate goal of these mining machines is to create the perfect hash that can solve the cryptographic puzzle and verify the transactions on a block. The successful miners earn the block reward and the transaction fee.
How does Proof-of-Work Operate?
PoW is a mining mechanism that requires a considerable amount of skills and financial input from the consumers. Everyone can’t become a PoW miner. These miners need to purchase expensive hardware for computation.
They also need to possess technical skills, must arrange a steady power source, book land for setting up the farm, and hire labor. Furthermore, the mining rigs dedicated to PoW blockchains are notorious for requiring a massive amount of power input.
The miners have to purchase the latest digital processors that are not only expensive but also rare. When users perform transactions on the blockchain, it is collected on a block. Each block is protected by a unique cryptographic signature.
Miners compete with each other to find the correct 64-digital hexadecimal key or hash to verify the block and add it to the main blockchain.
The first miner to find the correct hash can collect the transaction fee offered by the blockchain users and they also earn the block reward in the form of newly minted coins from the genesis blockchain.
Advantages of Proof-of-Work
Proof-of-Work offers strong security protection against exploits, data manipulations, and hack attacks.
This model ensures true decentralization of a blockchain network and verifies transactions without any error margins.
Miners in the network are incentivized to perform better and improve constantly to keep earning rewards.
Limitations of Proof-of-Work
The transaction speed and the duration for verification of a block are very slow.
The transaction fees can be high and they can undergo inflation on account of the increasing trading volume.
The power input requires for running PoW mining farms is considerably high and is often subjected to criticism.
Miners need to have the extensive technical knowledge and financial means to set up a PoW mining farm.
What is Proof-of-Stake?
Proof of Stake of the PoS consensus model was invented by two computer scientists Scott Nadal and Sunny King. The first PoS cryptocurrency was Peercoin introduced in 2012. This is a type of consensus model that depends on the total number of staked cryptocurrency positions reserved by miners.
There is no need for competing against each other to find the correct hash key first with PoS. This model uses a randomization protocol that automatically selects the miners to validate the new block. However, the probability of selection increases based on the amount of staked cryptocurrencies by miners.
Therefore, the nodes that wish to become PoS miners need to stake a considerable amount of cryptocurrency to qualify. In the PoS model, the newly added blocks are called minted rather than mined.
How does Proof-of-Stake Work?
Proof-of-Stake blockchains contains an arbitrary selection of nodes to nominate them as the next validator for every new block. Since miners are not competing with each other to solve the cryptographic puzzle first therefore there is no need for setting up heavy-duty mining machines.
Therefore, the power input required by the PoS blockchains is considerably lower. Nodes can stake cryptocurrencies to get picked as the next validator. The selection process is based on a randomization protocol that is part of the blockchain network.
The miners with the largest staked positions get picked more frequently on account of reliability. To eliminate favoritism towards the PoS miners, some solutions are adopted by PoS blockchains:
Randomize Block Selection
This solution enables the blockchain to combine the smallest hash value node with the largest stake position. In this manner, the problem of favoring the wealthy miners is averted, and a more judicious consensus model is.
Coin Age Selection
Coin Age Selection goes one step further than counting the total staked cryptocurrencies on nodes for picking the next validator. The new validators are nominated based on their coin age and cool-down time.
Every time a validator mints a new block, its coin age resets to zero. The same node will have a cool-down time before it can forge a new block. Validators can calculate coin age cool-down time as follows:
Coin Age = Number of Staked Cryptocurrencies x Total Duration of Staked Positions
Different blockchains implement a varied sets of rules for transaction verification using PoS. However, the PoS blockchain implements Fishermen Regulations which entails that any validator found guilty of foul play can get blacklisted or disqualified. When a malicious validator is barred, they can lose their staked cryptocurrencies.
Some PoS blockchains allow the validators to withdraw their staked positions and withdraw their rewards at any point. Under both above circumstances, the blockchain is liable to re-check all the verified transactions to prevent any fraudulent activity.
What is Delegated Proof-of-Stake?
Whenever there is an account for the Proof of Stake model, it cannot complete without discussing the Delegated Proof of Stake or DPoS. This is a type of sub-classification or modification of the PoS mechanism.
Rather than picking only validators like the PoS model, the DPoS mechanism depends on a group of delegates to perform on behalf of all nodes in the network. These delegators or witnesses are nominated by stakeholders voting. Every crypto investor gets one vote and they can pick their favorite witness.
For every new block, the blockchain picks 20-100 new witnesses that may or may not be validators for the previous blocks. In return for nominating the witnesses, the stakers can share the block reward and transaction fees they earn.
The reward share of a nominator is based on the ratio of their staked position in every election. If one delegator has a 4% share in the total witness election they earn a reward in the same percentage.
Each user may qualify for the block rewards, the right to verify a transaction and mint new blocks. If an assigned user is unable to complete the verification process, the block is missed.
However, the blockchain assigns the same transaction to the next witness to earn rewards and mint blocks. The benefit of the DPoS mechanism is that it can increase the blockchain performance and make the network more coherent.
Cardano, EOS, BitShares, and TRON are some of the most popular blockchain networks that use DPoS.
Advantages of Proof-of-Stake
PoS blockchains are very power efficient and they require 99.9% less power input in comparison to PoW blockchains.
The PoS model does not compromise the decentralization ability of a blockchain unlike some of its other contemporaries.
PoS blockchains are also deemed to be more secure in comparison to Po. The cost of launching an attack on the PoS blockchain is very high therefore it becomes very unlikely to happen.
PoS can prepare a blockchain for onboarding new protocols such as sharding that are ideal for increasing its scalability without compromising on its security.
Limitations of Proof-of-Stake
PoS developers make the blockchain complex to understand to address vulnerabilities such as DDoS attacks, staking issues, and long-range exploits.
PoS blockchains can suffer from the issue of centralization. It means that the validators with the highest amount of staked cryptocurrencies can end up with the largest number of newly minted cryptocurrencies. Therefore, it can create inequality in the blockchain network.
If the hackers can gain access to the 51% hash rate of a PoS blockchain, launching the hack can become cheaper for them. Threat actors can also achieve this feat by convincing the validators to join their cause with prospects of a massive bounty.
PoS blockchains suffer from a paradox where the validators need cryptocurrencies to mint new blocks. However, validators only earn new cryptocurrencies as a reward for minting. This issue is solved by pre-mining some coins in advance to mine the first block.
Comparison Between Proof-of-Work and Proof-of-Stake
The mining mechanism of PoW and PoS are very distinct from each other. The PoW mining methods require a considerable amount of hardware and energy input. However, the PoS mechanism depends mostly on software and running the digital algorithm.
At the same time, it also needs a very small percentage of power input in comparison to the former. PoW miners do not need to stake any cryptocurrencies while PoS miners cannot operate without offering staked positions.
The estimated energy requirements for PoW blockchains can make up for 0.21% of the total power consumption of the world annually for cryptocurrencies like Bitcoin. On the contrary, the PoS blockchains can operate effectively using only a fraction of the power that is consumed by PoW blockchains.
PoW blockchains ensure true decentralization and they can keep operating fully automated. At the same time, these blockchains adopt a democratic mode of governance and they are also trustless networks making way for wider financial inclusion.
On the other hand, there are some compromises on decentralization when it comes to PoS blockchains because they favor the stakeholders who have the largest stakes or investment positions in the network.
PoW blockchains like Bitcoin are famous for being secure and have avoided all hack attempts thus far. However, they are vulnerable to 51% attack. Meanwhile, PoS blockchains are considered more secure for the users because they require the miners to stake cryptocurrencies to qualify for becoming a validator.
In case of foul play or lapse of verification the validators can lose their staked currencies therefore they are bound to be more authentic and careful.
The reward for the PoS blockchains depends on the total amount of the staked positions they have offered to the network. Contrariwise, the PoW blockchain rewards are proportional to the size and duration of the transactions on the block.
PoS blockchains offer advantages such as environmental safety, security for users, scalability, and less expensive operational requirements for the validators. On the other hand, the PoW blockchain users get benefits like the best decentralization, sustainability, and high mining rewards.
The biggest risks associated with the PoS blockchain are the complexity of the blockchain network to prevent the issues such as technical errors, DDoS attacks, inaccurate calculation, and minimizing the error of margin when assigning rewards to the validators.
This model also suffers from setbacks such as favoring the validators based on the amount of total staked cryptocurrencies.
PoW mechanism is vulnerable to 51% attack that can expose it to issues like Double Spend. Furthermore, this model also requires a massive amount of power supply to function which is opposed by environmentalists, and increases its operating costs exponentially.
PoW and PoS are two of the most popular and talked about consensus mechanisms on account of their association with the two biggest blockchain projects namely Bitcoin and Ethereum. There is the ability in every blockchain to evolve and upgrade its existing protocols.
To this end, the Ethereum blockchain has shifted from PoW to PoS consensus algorithm. By comparing both models with each other, crypto investors can improve their trading strategies and make informed investment decisions.