PoW as a concept was first proposed by Cynthia Dwork and Moni Naor in their 1993 paper, “Pricing via Processing or Combatting Junk Mail.” In this work, the authors outline that “The main idea is to require a user to compute a moderately hard, but not intractable, function in order to gain access to the resource, thus preventing frivolous use.” In this paper, the designers of proof of work indicate that “we have designed an access control mechanism that can be used whenever it is desirable to restrain, but not prohibit a resource.” This is extremely important for money in our present-day fiat system. Since money printing simply requires a bank to open a new loan account on behalf of another party, which prevents healthy deflation, it is paramount that any new money used outside of fiat has this prohibitive (or at least deflationary) mechanism to keep a currency and its purchasing power healthy overtime.
Using this paper, Satoshi Nakamoto repurposed this PoW concept, to enable agreement on the state of a distributed ledger on the Bitcoin protocol. The distributed ledger is simply a detailed account of who owes who money and how much money is in each account. If you think of your group of friends and how each of you may pay for coffee one day but concert tickets the next, it gets difficult to fully see who owes what for each activity. The PoW mechanism helps the group of friends or “nodes” in the case of crypto to all agree on what the balances are on the ledger for the various participating nodes. This PoW is a continuous process that is ALWAYS happening on Bitcoin, providing economic incentives for the miners, preventing the double-spend problem (kind of like a bounced-check), scaling the network, and being further prohibited in the future to ensure that the resource doesn’t run out all at once from hyper competitive mining practices. I just said a lot of words, but half of you likely don’t have any idea what they mean.
So, the quick and dirty is essentially that computers all over the world listening to the Bitcoin network are aiming to find a VERY LARGE number that less than the random number generated by the algorithm being used on the network, which in the case of Bitcoin is SHA-256 and this random number is referred to as the HASH. The computational power required for this ensures there is a difficulty target for each block . More or less, these computers have to do the work outlined by the SHA256 algorithm to find a number slightly less than that produced by the algorithm. Everything you’re doing online has a process like this associated with it since computers talk in 1s and 0s while we use words and symbols to communicate ideas. In another way, the SHA256 takes the data you type or click, changes it to ones and zeros while computers on the network WORK or COMPUTE to find the correct combination of those 1s and 0s to create a hash that validates what the data being processed. Everyone with me? Great. Not that hard, right? This is why when you hear people talking about this they will say that the computer is “solving a puzzle” – it’s not. The computer is simply looking for the correct number much like a pick by lottery. Someone has to pull the numbers out of the bowl and that’s what miners do.
Okay, so what is Proof of Stake (PoS) then?
This consensus mechanism was first formerly proposed in 2012 by Sunny King (a pseudonym) and Scott Nadal in their paper, “PPCoin: Peer-to-Peer Crypto Currency with Proof-of-Stake”. In this paper, the authors were aiming to create a hybrid consensus model with PoW to help with issues of energy consumption associated with PoW (even though Bitcoin uses less than ½ the energy as traditional banking). It wasn’t until the wonderful Vitalek Buterin and the Ethereum development team isolated PoS and moved its network from PoW to a PoS mechanism, an effort known as “the Merge” which completed in 2022. For PoS, instead of “mining” blocks using the SHA256, Ethereum uses the Keccak 256 algorithm where validators “mint” new blocks. In the case of Ethereum, the reason it’s called PoS, is because to be a validator, a deposit of 32 ETH is required to ensure that the validator behaves in an honest manner. This 32 ETH stake in the network ensures that the validators behave properly as the stake can be reduced if the validator is found to be dishonest. Critics argue this means that Ethereum validation favors the rich, however it ‘s important to note that the economy-at-scale discounts for the rich regarding processors and computers used for Bitcoin mining can be seen as just as preferential to the rich. So don’t get too caught up on that for now.
The validators work to ensure the pending transactions are accurate and fully paid by all parties and then sign off on that block and publish it to the chain and are rewarded for it. So long as the stake is higher than the transaction fee reward, it’s likely the validators can be trusted. To ensure that validators do not simply rug pull the network or validate tons of fraudulent blocks before leaving, the rewards and deposits from the validators are time-released. Since you have to have a node AND the money, this means not everyone can be a validator using PoS, unlike PoW where anyone with a node can mine. This set up makes it more energy efficient. Note here that Ethereum validators do not COMPETE using “work” to validate. So, how is a validator chosen for each block? Is it just the rich people with 32 ETH who haven’t been punished? That would seem unfair. Well, on Ethereum, another algorithm is used, Keccak-256 which uses variables including the full staked amount, along with a randomness selection to ensure fairness, though the larger staked validators are more likely still to be picked, there is a fighting chance for those with less staked. This implies then that if a validator is dishonest they are less likely to be chosen to be a validator in the future, effecting both present and future finance of all participating validators.
So, there you have it, Proof of Work and Proof of Stake, the down and dirty. I really appreciate everyone taking the time to educate yourselves about this technology. It is the financial tech of the future you will need to navigate the uncertainty of the future. Again, thanks so much for coming by and we will see you in the next episode.
EP 6 Consensus & Crypto