Fiat currencies, Blockchains, and Consensus Protocols

Currencies such as the US dollar, the British Pound, and the Euro are called fiat currencies or fiat money, which means they are printed and regulated by a formal authorization or proposition or a decree. This central authority is the national central bank of a country (or in the case of the Euro are the national central banks within the Eurozone) and is the official body that gives a fiat currency its value and also adds certain complicating elements to the bill to make sure no one can just print exact replicas of that money in their homes.

Cryptocurrencies like Bitcoin and Ethereum on the other hand, are assembled on what’s known as a blockchain network. A blockchain is basically a distributed decentralized ledger, spread across nodes on a network. These nodes verify the creation and storage of new units of money on that network. But how does this system replace the central banks and prevents people from creating money out of thin air?

A consensus protocol is a method by which the majority (%51+) of the participants of the blockchain network (or nodes) reach a consensus to verify the authenticity of a newly created money. There are several types of consensus protocols used by different blockchains, including Proof of Work (PoW), Proof of Stake (PoS), Proof of Space, and Proof of Elapsed time. But PoW is by far the most popular consensus protocol used by blockchain networks.

What is Proof of Work?

Most Blockchains including the one on which Bitcoin, the first-ever cryptocurrency is generated, use the PoW consensus protocol. In 2009, an unknown person who goes by the name “Satoshi Nakamoto” used this algorithm to create the world’s first-ever cryptocurrency, Bitcoin. In a blockchain that uses Proof of Work, every node on the network is competing with other nodes to guess an enormously large number called a hash value as a way of verifying the transactions on the network. Nodes put up huge processing efforts to solve this difficult math problem and as a reward, they are paid a predetermined amount of the native cryptocurrency of that blockchain. The verified transactions are then put into a block and added to the chain of the previous blocks, earning the name “blockchain”. That enormous hash value is produced by a complicated computer code called a hash function, which takes any input and turns it into a fixed-length chain of characters. In the case of Bitcoin, the hash function SHA-256 generates a random 256 character long number of ones and zeros. The only way for someone to produce this number is by using brute force and significant computational processing efforts, so if you have this number it means that you have indeed put in the required work and are worthy of being rewarded with Bitcoin, hence the name “Proof of Work”. This process is called mining and is how new units of money are created on a blockchain network. The more nodes there are on the blockchain, the more difficult it becomes to verify new transactions since the majority of the nodes population must confirm the authenticity of the transaction. Consequently, mining becomes more difficult and energy-intensive as more miners are added to the network.

What is Proof of Stake?

In Proof of Stake, instead of having advanced computers constantly cranking out hashes by consuming ungodly amounts of electricity to earn cryptocurrencies, you as a node on the network have to prove that you are already holding some coins on the network! Instead of a free-for-all competition among miners, we have validators who have to buy into a lottery for the chance to be one of the nodes (users) to create or check a block of transactions. Each validator puts up their own desired amount of cryptocurrency which is then locked up and then only a few of the validators, instead of many thousands, are randomly selected to solve the math problem. Instead of competing against each other, the block of transactions is only validated once all of the selected validators have solved the math problem. This way, contrary to Proof of Work, you can’t gain an advantage by adding more computers to your setup.

As mentioned before, validators stake some of their cryptocurrencies as collateral. So if validators create or confirm a fraudulent transaction, they are punished by losing some of their collateral. This process is called staking and acts as the insurance mechanism to combat the creation of fake blocks.

Proof of Work vs Proof of Stake

In the case of PoW, the math problem only exists to make it inherently expensive to create and verify transactions. These math problems are only solved when enormous amounts of electricity are turned into computational processing efforts, a process that takes a heavy toll on the environment by creating lots of carbon emissions. Due to the competitive nature of PoW, the advanced hardware used for solving math problems must be replaced with a new better one every few years which creates huge amounts of electric waste. According to the research by the University of Cambridge in the UK, it is estimated that as of November 2018, the top six cryptocurrencies including Bitcoin and Ether, consumed between 52 and 111 terawatt-hours of energy every year, enough to provide Belgium with its entire energy consumption in 2016!

Proof of Stake is much less energy-intensive, doesn’t require advanced hardware specialized for only one task which is solving an otherwise useless math problem, and has to be replaced with another piece of more advanced hardware every few years, cannot be exploited by rich people who can buy more supercomputers and create mining farms to increase their chance, and is, therefore, more decentralized and is incredibly more environment-friendly. Cardano with a market cap of almost $30 billion and Solana with a market cap of $20 billion are two very large cryptocurrencies that use Proof of Stake.

Ethereum 2.0

Ethereum is by far the most important and influential blockchain in the world. It is the host of Ethereum’s native coin the Ether or ETH which is the second most valuable cryptocurrency on the market right after Bitcoin. It also hosts hundreds of thousands of cryptocurrency tokens, metaverse ecosystems such as Axie Infinity and The Sandbox, and many other decentralized projects. Ethereum is switching from the Proof of Work consensus to the Proof of Stake consensus, evolving into a new version of itself called Ethereum 2.0 which is estimated to reduce its carbon footprint by up to 99.95%. We’ve covered the topic of Ethereum 2.0 in a separate article in detail so be sure to check it out.

Final points

Shifting from Proof of Work to Proof of Stake is a major technical challenge as well as a complex cultural challenge since many people have already invested in expensive hardware setups to mine cryptocurrencies and switching to Proof of Stake will render those setups pretty much obsolete. With Ethereum deciding to embrace Proof of Stake, the shift seems inevitable and many other major blockchains might follow Ethereum’s footsteps, but Bitcoin will probably never leave the Proof of Work protocol and remain a country-size consumer of electricity as long as there are Bitcoins to mine.