Crypto Trends – Fifth Edition

As we expected, we have received many questions from readers since publishing Crypto Trends. In this edition we will give the most common answers.

What kind of changes are coming that could be game changers in the cryptocurrency sector?

One of the biggest changes that will affect the cryptocurrency world is an alternative method of block verification called Proof of Stake (PoS). We will try to keep this explanation at a fairly high level, but it is important to have a conceptual understanding of what the difference is and why it is a significant factor.

Note that the technology underlying digital currencies is called blockchain, and most current digital currencies use a validation protocol called Proof of Work (PoW).

With traditional payment methods, you have to trust a third party to settle your transaction, such as Visa, Interact, or a bank or a check clearing house. These trust companies are “centralized,” meaning they keep their own private ledger that stores the transaction history and balance of each account. They will show you the transaction and you must agree that it is correct, or start a dispute. Only the parties to the transaction see it.

With Bitcoin and most other digital currencies, ledgers are “decentralized,” meaning everyone in the network gets a copy, so no one has to trust a third party, such as a bank, because anyone can verify the information directly. This verification process is called “distributed consensus”.

PoW requires “work” to verify a new transaction to enter the blockchain. With cryptocurrencies, that validation is done by “minors,” who must solve complex algorithmic problems. As algorithmic problems become more complex, these “miners” need more expensive and more powerful computers to solve the problems ahead of everyone else. “Mining” computers are often specialized, usually using ASIC chips (Application Specific Integrated Circuits), which are more efficient and faster at solving these difficult puzzles.

Here is the process:

  • Transactions are bundled together in a ‘block’.
  • Miners verify that transactions within each block are valid by solving a hashing algorithm puzzle, known as a “proof of work problem”.
  • The first miner to solve the block’s “proof of work problem” is rewarded with a small amount of cryptocurrency.
  • Once verified, transactions are stored on public blockchains across the network.
  • As the number of transactions and miners increases, so does the difficulty of solving the hashing problem.

While PoW has helped get blockchains and decentralized, trusted digital currencies off the ground, it has some real drawbacks, especially with the amount of time these miners are trying to solve the “proof of work problem” as quickly as possible. According to Digiconomist’s Bitcoin Energy Consumption Index, Bitcoin Miners are using more energy than 159 countries, including Ireland. As the price of each bitcoin increases, more miners try to solve problems, consuming more energy.

All this energy consumption just to validate transactions has inspired many in the field of digital currency to look for alternative methods of verifying blocks, and a prime candidate is a method called “Proof of Stake” (PoS).

PoS is still an algorithm, and the purpose is the same as proof of work, but the process to reach the goal is quite different. With PoS, there are no miners, but instead we have “validators”. PoS relies on the trust and knowledge that all the people who are validating transactions have skin in the game.

Thus, instead of using power to answer the PoW puzzle, a PoS validator is limited to validating the percentage of transactions that reflect his ownership stake. For example, a validator who owns 3% of the available ether can theoretically only validate 3% of the block.

In PoW, your probability of solving the proof of work problem depends on how much computing power you have. With PoS, it depends on how much cryptocurrency you have, the more stake you have, the more likely you are to solve the block. Instead of winning crypto coins, the winning verifier receives a transaction fee.

Validators enter their stake by ‘locking up’ a portion of their fund tokens. If they try to do something malicious against the network, such as creating an ‘illegal block’, their shares or security deposit will be confiscated. If they do their job and don’t breach the network, but don’t win the right to validate the block, they get their stake or deposit back.

If you understand the basic difference between PoW and PoS, that’s all you need to know. Only those who plan to become miners or validators need to understand all the ins and outs of these two validation methods. Most of the general public who wish to hold cryptocurrencies will simply buy them through an exchange and not participate in the actual mining or validation of block transactions.

Much of the crypto sector believes that for digital currencies to survive in the long term, digital tokens must move to a PoS model. At the time of writing this post, Ethereum is the second largest digital currency behind Bitcoin and their development team has been working on their PoS algorithm “Casper” for the past few years. It is expected that we will see Casper implemented in 2018, putting Ethereum ahead of all other major cryptocurrencies.

As we’ve seen before in this sector, major events like the successful implementation of Casper can send the price of Ethereum much higher. We will keep you updated on future issues of Crypto Trends.

Stay tuned!