Investor’s Definitive Guide to Proof of Work and Proof of Stake (Abridged)

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IIf you know anything about crypto and also read the news, I’m sure you’ve read about crypto mining. And if you’ve read about crypto-mining, you’ve read about how Bitcoin depends on proof-of-work (which is so so so terrible for the environment) and how Ethereum is pass proof of work at proof of participation coming soon (which is so so so better for the environment).

What is better? In answering this, most proof-of-work vs. proof-of-stake coins become too technical or are too obviously biased. From an investor’s perspective, you just want to know the facts and the trade-offs so you can make an investment decision.

So here is the “Definitive Investor’s Guide to Proof of Work and Proof of Stake (Abridged)”. An actual book could be written about it, so many technical nuances will be masked to avoid word count drift. But first, a little detour which, I promise, is relevant…

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It might surprise you, dear reader, but investment and software engineering are not that different. Fundamentally, investing is about making trade-offs. Just like software engineering.

By investing, you have a certain amount of capital and you allocate that certain amount of capital in a certain way. When you choose to invest in Thing 1, you cannot also invest this same capital in Thing 2. And by choosing to allocate to Thing 1 rather than Thing 2, the allocator takes into account several elements such as the return expected, the risk profile or if you invest in Thing 2 would be grounds for termination because the boss of the boss doesn’t like Thing 2 for some reason.

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In software engineering, you have a product that has a particular behavior and structure. An engineer will design something that behaves a certain way and make structural decisions for the code. These structural decisions determine how easily it will be possible to make adjustments down the road.

Cryptocurrencies aim to operate their networks without the (broad) use of third parties. To do this, network participants need a way to decide what’s going on and come to a consensus. Enter consensus mechanisms. There are many consensus mechanisms, but the two most important are proof-of-work (PoW) and proof-of-stake (PoS).

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Between the two, there are compromises. But the most important thing to know about consensus mechanisms is that they need resilience to keep attackers away from the network (whether competitors, governments, or a cabal of wealthy individuals). So let’s take a piecemeal approach to the Investor’s Guide by first defending PoW (in the context of Bitcoin); second, to defend the points of sale (in the context of Ethereum); and third, outlining (some of) the trade-offs.

In defense of proof of work

There are so many horrible similes people use to describe proof of work. Here is one of mine.

There is a lottery. To win the lottery, you must buy the winning lottery ticket. To buy a lottery ticket, you need a computer capable of buying lottery tickets. The more computers you have, the more lottery tickets you can buy. If your lottery ticket matches the winning number, you win. So, the more computers you have, the more chances you have of winning the lottery.

In bitcoin, which uses PoW, miners (as PoW lottery ticket buyers are called) use application-specific computers to guess the number on the winning lottery ticket. These computers have chips that can guess and run on electricity. The only way to get the right number is to do the work.

Read more: What is Proof of Work?

Proof of work has distinct advantages and disadvantages:

  • PoW is a resilient way to build distributed consensus and deter spam. Proof of work has been used in Bitcoin since its launch in 2009 to confidently run an open, decentralized, and borderless payment network. Bitcoin’s proof-of-work mechanism worked just as well when a bitcoin was worth 6 cents as when it was worth $60,000. Conclusion: Proof of work works, and it works very well.
  • That said, proof-of-work consensus mechanisms are hardware-intensive and rely on high demand microprocessors. Therefore, investing in proof of work can be time consuming in the event of supply chain disruptions (as we have seen recently).
  • Due to the constant need for electricity and storage space, there are centralized geographic choke points where mining tends to cluster in locations with ample space and good electricity. market. So even though miners may be spread across multiple machines, they could all end up settling, for example, in the Sichuan Province of China.
  • Proof of work has a double edged sword, depending on your specific setting. It uses electricity. I’m not going to argue whether bitcoin is a valiant use of electricity or it uses the the right kind of electricity, but he certainly uses it. Yes, proof of work could monetize otherwise wasted electricitystabilize power grids and boost local economies, but bitcoin mining has revitalized some otherwise obsolete fossil electricity generating stations.

In Defense of Proof of Stake

There are so many horrible comparisons people use to describe proof of stake. Here is one of mine.

There is a lottery. To win the lottery, you need to buy a lottery ticket. To be eligible to purchase a lottery ticket, you must be chosen. To be chosen, you must commit money to the lottery. The more money you commit, the more likely you are to be chosen. If you are chosen to buy a ticket, your ticket will automatically match the winning number and you win. Thus, the more money you have pledged, the more chances you have of winning the lottery.

In Ethereum, which will be optionally use proof of stake, validators (as PoS lottery ticket buyers are called) are randomly chosen to win the lottery based on the amount of capital they wagered. The way to get picked more often is to wager more capital.

Read more: What is proof of stake?

Proof of stake has advantages and disadvantages:

  • This is an effective way to build distributed consensus. While nothing is as proven as PoW, there are cryptocurrencies that have been using PoS successfully for several years.
  • In the world of Ethereum in particular, it is very expensive to become a validator. To become a validator and participate in the lottery, you need to pledge 32 ETH (about $60,000). Granted, there is a mechanism where you could pledge less ETH in a pool of capital which is then staked, but it is not the same thing. The high upfront cost could result in a “rich blockchain” with only wealthy capital holders participating in validation.
  • PoS has a double edged sword, depending on your specific setting. It uses capital. In a way, it’s advantageous because anyone, anywhere with enough money can become a validator. There is not the same risk of geographic centralization as with PoW (although there may be given the inequality of wealth across the world). That said, since PoS only requires capital, the barrier to entry can be lower.

(Some of) compromises

As mentioned earlier, this could take an entire book. The following trade-offs between PoW and PoS are not exhaustive.

It is easier to attack a PoS network because PoW is more resilient. Stealing some thoughts from Andreas Antonopoulos, all it takes to attack a PoW network is “electricity and hardware brought together at the right time in the right place with the right incentives” and logistically this is becoming increasingly difficult to achieve. With PoS, all it takes is money. To Ethereum’s credit under PoS, it will still take a lot of money to attack the network, but it takes less coordination.

That said, PoS is theoretically more accessible because it only requires capital. Granted, that might be a lot if you look at Ethereum (about $60,000), but the coordination mentioned in the previous paragraph might be a barrier to entry that doesn’t exist in proof-of-stake.

Along the same lines, proof-of-stake is more mobile than proof-of-work. Given the electricity consumption needed for proof of work, a government can determine where miners operate and shut down individual sites. Moving a proof-of-work operation that has been stopped to a new location is a lot of work. We have seen this happen when China has banned bitcoin mining last year, which led to a decline in network activity which eventually recovered (although it took a long time). Moving a PoS operation would be trivial in comparison.

The last one I’ll cover (but not expand on, because I don’t really think it should matter) is that PoS doesn’t use electricity and PoW does. So if you are a single issue investor, investing in PoW might not even be a consideration for you. There are merits at PoW and I’ve spent years advocating for bitcoin mining (privately and professionally), but in the end, I’m not here to tell you how to think or what to do.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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