Blockchain
Proof-of-work (PoW) is a blockchain consensus mechanism that incentivizes network validation by rewarding miners for adding computational power and difficulty to the network. It is a lottery system where miners increase their likelihood of receiving the reward the more power they add.
The consensus mechanism represents about 60% of the total crypto market capitalization.
The history of proof-of-work
The origin of proof-of-work can be traced back to 1993 when Cynthia Dwork and Moni Naor were looking for a solution to deter email spam and DoS attacks. Their paper on pricing via processing outlined the basics of proof-of-work.
In 1997, Adam Black integrated their idea into Hashcash. His algorithm made it difficult for spammers to send large volumes of emails by requiring senders to include a computationally expensive string of characters in the email.
The solution to spam was essentially increasing the cost to send individual emails. This experiment proved that you could use computational difficulty to represent the value of something online. This inspired others to see if they could use the same idea to make a digital representation of cash.
The idea made an appearance again in Nick Szabo’s so-called ‘Theory of Collectibles’ and the paper “Shelling Out: The Origins of Money.” In 2004, these ideas inspired Hal Finney to create a version of it called reusable proof-of-work. And in 2009, Satoshi Nakamoto famously created the proof-of-work consensus mechanism for Bitcoin. It was the first decentralized implementation that solved the double spending problem and made bitcoin the first successful form of digital cash.
What made proof-of-work different?
Previous iterations before Bitcoin failed because they required centralized entities to prevent the double spending of digital tokens.
Satoshi’s improvements to proof-of-work used game theory to solve this problem. It made a way to incentivize anonymous volunteers called miners to verify the validity of all Bitcoin transactions – ensuring that no one is double-spending. This invention was the first time a decentralized network of participants could secure trust without a centralized intermediary.
This gamification incentivizes network participation so well that nation-states such as El Salvador use bitcoin as a reserve currency. But as the cryptocurrency currently employs approximately 99 terawatt hours of electricity per year, many believe this growth is unsustainable.
The “work” in the proof-of-work consensus mechanism is the source of these unsustainability concerns. To explain, let’s first outline the fundamentals.
Read More: The Beginner’s Guide to Consensus Mechanisms
Proof-of-work (PoW) fundamentals
Maintaining the integrity and security of all transactions in the network is the ultimate objective behind the proof-of-work consensus mechanism. Here is a breakdown:
The work(ers)
Proof-of-work blockchains are supported through a network of decentralized computers called nodes. They are tasked with two things: accepting batches of transactions from other nodes and validating (or proposing) new blocks of transactions to the network.
These nodes are also called miners because they spend computing power and resources in return for the network’s underlying cryptocurrency.
The “work” in proof-of-work is the computational power nodes have to contribute in validating a new block of transactions. This power is represented by the SHA-256 cryptographic hash function, and it sets this consensus mechanisms apart from its counterparts.
An algorithm called the difficulty adjustment ensures that it will take the entire network a fixed set of time to validate new blocks of transactions. The difficulty adjustment occurs approximately every 2,016 blocks (about once every two weeks) to maintain the target block time of 10 minutes. Miners coming and going from the network on an individual basis do nothing to affect difficulty level minute to minute, or day to day.
Miners win the reward when they guess a hash that falls below the threshold provided by the network. Once a miner finds the valid block hash, it broadcasts this information to other miners who can quickly validate and add the new block to their blockchain copies. This validation process eliminates the possibility of miners including malicious transactions, such as an attempt by a user to double-spend coins.
The reward
There is an encoded rule regarding the amount paid to the miner who completes the proof-of-work. At the time of writing, miners earn a fixed 6.25 BTC per block, plus any user transaction fees. This reward potential incentivizes miners to compete in the proof-of-work and remain honest, as any attempt to cheat the system would waste resources.
The reward amount is set to half every 210,000 blocks (approximately four years). This deflation rate is referred to as the halving cycle. Many fear that if bitcoin’s price fails to keep pace, miners will lose the incentive to participate. But as miners disconnect from the network, the difficulty level drops accordingly. This balancing act makes the cost to mine bitcoin drop as well.
The economics of bitcoin mining though are not straight forward. There are many financing factors that drive miners to stay online even when they are unprofitable.
Read more: Is Bitcoin Mining Still Profitable? The Economics Explained
The difference between proof-of-work and proof-of-stake
The main difference between proof-of-work and proof-of-stake is the difficulty requirement. In proof-of-stake, validating nodes compete for blocks by locking or delegating more of the network’s token to the network. This requires less energy but can make the entry barrier more expensive.
A proof-of-work consensus model is used more for cryptocurrency networks focused on payment and monetary use cases. Other blockchains, such as Ethereum, Cardano and Solana, focus on powering decentralized applications and utilize the proof-of-stake (PoS) model.
Read More: Proof-of-work vs. Proof-of-Stake
Proof-of-work examples
More than 60% of the cryptocurrency market capitalization utilizes proof-of-work algorithms. However, the most valuable networks implementing the consensus model are as follows:
- Bitcoin: The network is the world’s most secure and decentralized PoW system. Bitcoin’s success has primarily been attributed to Satoshi’s ingenious PoW engineering, which beyond security, provides sustainable economics for network participants.
- Litecoin: Litecoin launched in 2011 as a Bitcoin fork, copying aspects of the legacy network, such as its PoW consensus model. Litecoin is often called the silver to Bitcoin’s gold and remains among the top crypto assets by market value.
- Dogecoin: Meme-inspired cryptocurrency Dogecoin launched in 2013, implementing a PoW technology with roots traceable to Litecoin. Dogecoin and Litecoin enable faster transactions but are generally less secure than Bitcoin.
- Monero: Monero is a privacy-focused cryptocurrency that implements a proof-of-work algorithm. Its unique features, including ring signatures and stealth addresses, make it difficult to trace transactions on the blockchain. Monero’s proof-of-work algorithm is designed to be ASIC-resistant, meaning it is more accessible to individual miners rather than large mining operations.
- Bitcoin Cash: Bitcoin Cash is a cryptocurrency that was created in 2017 as a result of a hard fork from the Bitcoin blockchain. It utilizes a proof-of-work consensus algorithm, similar to Bitcoin. Bitcoin Cash aims to improve on the scalability and transaction speed of Bitcoin by increasing the block size limit to 32 MB. However, it has faced criticism for centralization due to the dominance of a few mining pools in its network.
How proof-of-work works
Bitcoin mining through proof-of-work works similarly to buying lottery tickets with a prize draw every 10 minutes. Anyone can participate by purchasing a Bitcoin mining machine and plugging it into the network. Although everyone has the same odds of being drawn, buying more tickets increases the statistical likelihood of winning the lottery.
In the above example, the lottery tickets represent the hash rate deployed, while the prize is the BTC reward paid for successfully creating a Bitcoin block. Hash rate is the number of hashes per second mining equipment can carry out to find the above-noted cryptographic hash function. The more efficient a mining device is, the higher chances a miner has of winning the block rewards. For instance, An S19j Pro machine can perform 104 terahashes per second (TH/s), the equivalent of 104 trillion guesses or tickets per second.
Meanwhile, users can join mining pools; comparable to office pools or syndicates. Joining the pool voluntarily would increase their chances of winning the lottery, unlike solo mining, where the odds of winning a Bitcoin block today are extremely rare.
However, every win on a public mining pool is split among the members in proportion to their hashrate. Mining pool participants are not obligated to remain in the pool. Many criticize pools for being a centralizing force in the network. But individual participants provide a counterweight to that centralization. They can leave the pool or syndicate and do so very easily, a feature that comes in handy if the pool attempts to become dishonest.
Like the lottery, the rules of participation and potential rewards are encoded in the Bitcoin software. Anyone can verify these rules and agree to play by them if they choose to set up a Bitcoin mining operation.
Proof-of-work and mining
Proof-of-work is closely intertwined with mining. PoW defines the exact process through which miners show peers that they have performed the required computation by generating a hash that matches the target for the block. On the other hand, mining focuses on adding a new block to the blockchain and receiving the associated coin rewards.
Considering how Bitcoin transactions are processed provides a clear insight into the relationship between PoW and mining. All user transactions on the Bitcoin network end up in a memory pool (mempool) from which miners select transactions to add to the next Bitcoin block. Every miner enters the race to create a new block for the Bitcoin blockchain, picking several transactions from the mempool and bundling them into a candidate block.
However, before a candidate block becomes accepted as valid, the miner must perform computations that generate a hash below the target set by the Bitcoin proof-of-work algorithm. The first miner to produce a matching hash for their candidate block broadcasts it to other miners, who can easily verify and validate its addition to the blockchain record.
The successful miner receives the block rewards and associated transaction fees, having added a new valid block to the blockchain. Thus, the Bitcoin blockchain height grows while the race for mining the next block begins.
Why is proof-of-work important?
The proof-of-work algorithm is vital for several reasons. The most compelling is that it provides a secure and decentralized mechanism for network participants to maintain the integrity of the blockchain ledger. PoW incentivizes miners worldwide to expend computing power to validate blocks, thus filling the role usually played by a central entity such as a bank.
Another primary benefit of a PoW is that it regulates the creation of new coins. In Bitcoin’s case, the algorithm includes a mining difficulty adjustment that stabilizes the rate miners can produce new blocks. Bitcoin’s code specifies a target of 10 minutes per block, with the algorithm designed to increase the difficulty of finding a new block hash if the hash rate grows to a point where miners produce blocks faster than the average.
Without the PoW-linked mining difficulty adjustment, miners can drain the BTC supply faster than required for a sustainable economy. Moreover, as the network’s hashrate on a PoW chain grows, it becomes impractical for a bad actor to attack the system.
A Braiins study puts the conservative cost of attacking the Bitcoin network through physical hashrate at $5.5 billion. However, such an operation is impractical to execute in the real world because the cost attack outweighs any perceived benefits. Besides that, a prospective attacker can immediately receive rewards for acting honestly and contributing hash power to Bitcoin.
Advantages and disadvantages
Being the earliest consensus model for blockchains, the pros and cons of proof-of-work systems have only become evident as the industry matures. Despite newer innovations, PoW remains the most proven, time-tested method for achieving consensus on a public blockchain.
Problems with proof-of-work
Energy usage
The most prevalent criticism of proof-of-work is that it wastes energy. Multiple research estimates that Bitcoin uses more energy than several midsized countries such as Norway and Argentina. Still, other findings assume that the Bitcoin network significantly contributes to climate change and will continue to do so as adoption grows.
Nonetheless, evidence points to the contrary regarding the impact of Bitcoin and its novel proof-of-work system. The Bitcoin network consumes significantly less energy than existing monetary systems and other major industries, including gold mining and financial sectors.
Another vital point to consider is that energy being the only variable in Bitcoin mining, incentivizes miners to seek out the cheapest methods, such as renewable sources. Over time, miners are adopting these cost-friendly energy channels to maximize profits. Industry estimates reveal that nearly 59% of bitcoin mining utilizes environment-friendly energy sources, much higher than other sectors and countries.
Additionally, Bitcoin’s PoW technology allows individuals and organizations to tap into the energy that may otherwise be wasted. This is especially true for power generated in locations such as oil drilling sites producing flare gas, agricultural regions harnessing biomass energy or jurisdictions where it is impracticable to transport such energy. The portability of Bitcoin mining machines allows miners to monetize such power and provide economic value to the local communities.
Scalability
Another common criticism against PoW systems such as Bitcoin is that they do not scale as efficiently as newer consensus models. Bitcoin advocates argue that Bitcoin’s unique positioning as a global monetary system means the delayed confirmation time contributes immensely to the network’s security. PoW systems are optimized for security and scale on secondary layers such as the Lightning Network implementations on Bitcoin and Litecoin.
Centralization
Lastly, critics also argue that proof-of-work consensus algorithms have become more centralized over the years. The increasing cost to entry and computing difficulty has consolidated network consensus decisions around a handful of major mining pools.
These pools largely control the consensus decisions of the network because they collectively have more hashing power than individual miners. But a lot of this power is contingent that the pools act in good faith — as contributors can exit the pool at any time.
For example, Bitmain, one of the largest manufacturers of cryptocurrency mining hardware, controlled several mining pools that had more than 43% of the hashing power in 2018. With a few strategic moves, Bitmain may have been able to execute a double spend attack. The damage that would have had on the network and their reputation probably prevented them from executing the attack.
What this means for investors
Contrary to the mainstream notion that PoW systems are harmful to the environment, the Bitcoin mining industry’s push toward renewable energy sources reveals that the technology may not have the impact they think. Advocates even argue that Bitcoin has the potential to be a net positive to the planet.
Tying the Bitcoin network’s security to a tangible real-world asset like energy makes the network more robust, especially at optimum hash rate. It also lets investors get exposure to the underlying BTC asset through mining stocks such as Riot Blockchain, Hive, Marathon Digital, and Hut8. Additionally, while other faster and more innovative consensus models have emerged in recent years, the underlying networks tend to become increasingly centralized.
Being a time-tested model for securing public blockchains means that PoW will likely continue to play a key role as the industry onboards more mainstream audiences. Rather than supersede the legacy consensus model, newer systems highlight the unique properties of PoW and make it more attractive to investors that prioritize security and censorship resistance.
The future of proof-of-work
Proof-of-work introduced the world to blockchains. Miners compete in a never-ending race to produce new blocks and collect associated rewards, thus making it increasingly difficult for bad actors to compromise the network. The novel consensus mechanism provides unparalleled security by incentivizing the use of computing power to protect the integrity of the underlying ledger.
The PoW consensus algorithm aims to provide a stable economy by regulating the coin’s issuance using the difficulty adjustment implementation. The coin’s supply is distributed more efficiently as miners cannot automatically boost their holdings or stake on the network by accumulating more tokens.
The legacy consensus model continues to power the largest market share of public blockchains and will likely always remain the most secure option for establishing consensus among decentralized networks.
