In the traditional settlement and clearing services, such as Visa, Mastercard, or SWIFT, a third-party intermediary service records and validates the transaction. Such entities have private registers that keep a copy of the deal while also debiting and crediting the requisite accounts.
All parties involved must trust the third-party service and cannot ask for a copy of the private register that has stored the transaction details.
On the other hand, cryptocurrencies such as Bitcoin depend on decentralized networks and distributed consensus systems. They use the blockchain to store the transaction details—a shared, public ledger that contains a record of every transaction that has ever taken place.
As anyone can verify the information contained within the blockchain, there is no need for a third-party intermediary service.
A blockchain contains all previous transactions in a sequential line of blocks. The blocks are shared publicly, making it easy to spot any change or tampering with the chain.
For a Proof-of-Work system to work, machines on the network called miners must audit and verify pending transactions on the blockchain.
Once a person sends their assets to the network and signs the transaction using their private key, miners will ensure that the transaction is legitimate.
The cryptocurrency miner’s job is to calculate a number representing all the information within a block (i.e., a block header) to be less than or equal to a set target number. To do this, the miner looks at the pending transactions in the network and selects and collects the block size’s (1 megabyte) worth of transactions.
The miner then passes the blocks into a cryptographic hash function called SHA-256, along with various metadata such as the miner’s Bitcoin client version (i.e., the current software version that the miner uses), a cryptographic hash describing the previous block, and the timestamp of the block.
The miner then repeatedly computes an output hash and submits these hashes to the network, which is a very computationally intensive operation. The miner is required to calculate a nonce, an arbitrary number between 0 and roughly 4.29 billion, that is added to the block header and then generate a hash for it.
This hash is then compared with the target, a large number that the miner’s guessed output has to fall below. If the miner’s solution falls below the target value, then it is considered a valid solution.
One of the criticisms of PoW is that it uses a high degree of computational power and resources. Bitcoin uses more energy than entire countries, and this energy consumption will only go up as the price of Bitcoin rises.
Competing for the rewards in PoW also requires sophisticated mining rigs. The cost of setting up a basic rig can be several thousand dollars, while, realistically, you will need a more sophisticated machine to earn higher rewards. PoW is also not very scalable, as the Bitcoin blockchain only allows for roughly five transactions per second.
Another consensus mechanism, and an alternative to PoW, is called Proof of Stake (PoS). It is considered to be more energy-efficient and scalable than PoW. The critical difference between the two is that only participants that currently hold cryptocurrency assets can participate in the consensus mechanism.
In other words, the system prioritizes those who hold existing amounts of the digital currency instead of miners who don't need to stake their assets for the prize.
A third consensus mechanism is Proof of Burn (PoB), which runs on allowing miners to "burn" virtual tokens. The more tokens you burn, the higher the number of blocks you're allowed to add to the blockchain. PoB is yet not as popular a consensus mechanism as PoW and PoS.
Given PoW's longevity and proven reliance, it has emerged as the most potent consensus mechanism so far. It has solved the double-spend problem and positioned itself as a realistic alternative to trusted third parties.
However, the criticisms of its scalability and energy use continue to persist. With the Ethereum blockchain moving to a PoS consensus system soon, it remains to be seen whether PoW will continue to be the dominant player.
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Blockchains. DeFi. Cryptocurrencies. Consensus algorithms. These are terms that you may have heard of in recent months, and with the recent boom in Decentralized Finance, have piqued investors’ interests. How does this obscure piece of technology work, and how can you benefit from it?