Understanding Proof-of-Work, Proof-of-Stake and Tokens

As we navigate the complex world of cryptocurrency for our clients, it’s especially important to have a clear understanding of how each network operates, how new tokens are created and the reason for their unique designs.

There are two major consensus mechanisms – algorithms used by distributed systems that allow the network to work together and stay secure – used by cryptocurrencies: proof-of-work and proof-of-stake. These methods are used to secure the blockchain, verify transactions, include transactions in the history of the blockchain and to create new coins and tokens.

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Bitcoin was the first cryptocurrency to implement proof-of-work – the consensus mechanism used by Bitcoin that allows the network to remain secure. You will often hear the term “miner” in the context of cryptocurrency. Mining the blockchain is referencing this proof-of-work mechanism. A tremendous amount of energy (computing power and electricity) is required to secure the blockchain, and thus the miners are rewarded by earning a distribution of new coins upon successfully auditing the blockchain.

All around the world, miners are competing to secure the Bitcoin blockchain and earn a monetary reward. The reward is currently 6.25 BTC, issued approximately every 10 minutes. This reward will eventually decrease to zero, as the supply of Bitcoin is capped at 21,000,000 coins. This cap exists because that is the maximum number of coins that can be generated, according to the code written by Bitcoin’s creator Satoshi Nakamoto.

Proof-of-work is a proven mechanism and thus trusted and used by Bitcoin. When the monetary value of the bitcoin network increases, miners are financially incentivized to join the network. This, in turn, strengthens the blockchain and improves security. Because of the tremendous energy needed to mine the Bitcoin blockchain, it is impossible for one single entity to take control of the chain, thus preserving the decentralization and integrity of the coin.

Developers quickly realized that proof-of-work blockchains have trouble scaling and created cryptocurrencies like Ethereum* (Ethereum 2.0 specifically) that now relies on proof-of-stake – where validators stake coins to win the right to verify a transaction and add it to the blockchain – as the consensus mechanism.

(Important note: Ethereum just had an update, EIP 1559, on its journey from Ethereum 1.0 (PoW) to Ethereum 2.0 (PoS), which has resulted in over 173,000 ETH being burned (destroyed). This so far has led to a 45% net reduction in new ETH token issuance, which many are speculating will continue to drive the price higher (supply vs. demand). As more ETH gets locked up for staking, supply will become more and more scarce, taking a page from the playbook of Bitcoin scarcity.)

Ethereum and other smart-contract-enabled blockchains process a significant number of transactions when compared to non-smart-contract coins such as bitcoin. Ethereum currently processes over 1,000,000 transactions per day, which will increase to many times more than that once the ETH 2.0 upgrade is complete. Compared to approximately 200,000 transactions per day on Bitcoin, it’s easy to see why scaling problems needed to be solved.

Ethereum, for example, is required to process its own transactions, execute smart contract transactions, NFT transactions, etc. Proof-of-stake is the ideal solution for the scaling problems that proof-of-work mechanisms are unable to currently solve.

Not all proof-of-stake coins operate with the same rules, though the validation concept is consistent from coin to coin. Market participants, often called validators, are required to “stake” (contribute) a certain number of coins to be able to help validate transactions. (This is essentially serving the same function as miners.) Each qualifying validator has the ability to earn a reward. The network rewards the validators based primarily on tenure.

To make this as simple as I can: The more powerful your computer and the more energy you put behind it, the greater your odds are of earning a proof-of-work mining reward. The bigger your wallet and the more steadfast your commitment, the greater your chances of earning a proof-of-stake validating reward. Increased dedication of resources toward validation leads to an increased likelihood of being a rewarded validator.

Tokens, on the other hand, are outside of the family of proof-of-work and proof-of-stake cryptocurrencies. They are not a currency on their own, but rather a unit of measure that exists on top of an existing cryptocurrency’s framework. They are typically used to represent physical assets, such as real estate or collectibles, digital assets such as processing power or storage and decentralized finance (DeFi).

Recommending an allocation to bitcoin for a client will depend on your investment thesis, recommending ethereum or other proof-of-stake coins will depend on your investment thesis and the same goes with advising on tokens. It’s important to note that each token is unique and any advice applicable to a specific token cannot be applied to other tokens – the same as if you were giving advice on individual equities. Not only is it important to understand the basics of cryptocurrency, but it’s even more important to know how cryptocurrency helps clients reach their goals.