Cryptocurrency All-in-One For Dummies. Peter Kent

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      Proof of work

      If you’re a miner and want to actually enter your block and transactions into the blockchain, you have to provide an answer (proof) to a specific challenge. This proof is difficult to produce (hence all the gigantic computers, time, and money needed for it), but others can very easily verify it. This process is known as proof of work, or PoW.

      For example, guessing a combination to a lock is a proof to a challenge. Going through all the different possible combinations to come up with the right answer may be pretty hard, but after you get it, it’s easy to validate — just enter the combination and see whether the lock opens! The first miner who solves the problem for each block on the blockchain gets a reward. The reward is basically the incentive to keep on mining, and it motivates the miners to compete to be the first one to find a solution for mathematical problems. Bitcoin and some other mineable cryptocurrencies mainly use the PoW concept to make sure that the network isn’t easily manipulated.

      

This whole proof-of-work concept has some downsides for blockchain technology. One of the main challenges is that it wastes a lot of computing power and electricity just for the sake of producing random guesses. That’s why new cryptocurrencies have jumped on an alternative wagon called proof of stake (PoS), covered in the next section.

      Proof of stake

      Unlike PoW, a proof-of-stake (PoS) system requires you to show ownership of a certain amount of money (or stake). That means the more crypto you own, the more mining power you have. This approach eliminates the need for the expensive mining extravaganza. And because the calculations are pretty simple to prove, you own a certain percentage of the total amount of the cryptos available.

      Another difference is that the PoS system offers no block rewards, so the miners get transaction fees. That’s how PoS cryptos can be several thousand times more cost-effective than PoW ones. (Don’t let the PoS abbreviation give you the wrong idea.)

But of course, PoS also has its own problems. For starters, you can argue that PoS rewards coin hoarders. Under the proof-of-stake model, nodes can mine only a percentage of transactions that corresponds to their stake in a cryptocurrency. For example, a proof-of-stake miner who owns 10 percent of a cryptocurrency would be able to mine 10 percent of blocks on the network. The limitation with this consensus model is that it gives nodes on the network a reason to save their coins instead of spending them. It also produces a scenario in which the rich get richer because large coin holders are able to mine a larger percentage of blocks on the network.

      Proof of importance

      Proof of importance (PoI) was first introduced by a blockchain platform called NEM to support its XEM cryptocurrency. In some ways, PoI is similar to PoS because participants (nodes) are marked as “eligible” if they have a certain amount of crypto “vested.” Then the network gives a “score” to the eligible nodes, and they can create a block that is roughly the same proportion to that “score.” But the difference is that the nodes won’t get a higher score only by holding onto more cryptocurrencies. Other variables are considered in the score, too, in order to resolve the primary problem with PoS, which is hoarding. The NEM community, in particular, uses a method called “harvesting” to solve the PoS “hoarding” problem.

      Here’s how Investopedia defines harvesting: “Instead of each miner contributing its mining power in a cumulative manner to a computing node, a harvesting participant simply links his account to an existing supernode and uses that account’s computing power to complete blocks on his behalf.” (See the section, “Harvesting,” later in this chapter.)

      Transactions: Putting it all together

      

Here’s a summary of how cryptocurrencies work (check out the preceding sections for details on some of the terminology):

      1 When you want to use cryptos to purchase something, first your crypto network and your crypto wallet automatically check your previous transactions to make sure that you have enough cryptocurrencies to make that transaction. For this, you need your private and public keys (explained in Chapter 3 of this minibook).

      2 The transaction is then encrypted, broadcast to the cryptocurrency’s network, and queued up to be added to the public ledger.

      3 Transactions are then recorded on the public ledger through mining. The sending and receiving addresses are wallet IDs or hash values that aren’t tied to the user’s identification, so they are anonymous.

      4 For PoW cryptos, the miners have to solve a math puzzle to verify the transaction. PoS cryptos attribute the mining power to the proportion of the coins held by the miners, instead of utilizing energy to solve math problems, in order to resolve the “wasted energy” problem of PoW. The PoI cryptos add a number of variables when attributing the mining power to nodes in order to resolve the “hoarding” problem that’s associated with PoS.

Cruising through Other Important Crypto Concepts

      Earlier sections of this chapter talk about the basics of cryptocurrencies and how they’re related to blockchain technology. This section digs into other factors that make cryptocurrencies so special and different from government-backed legal tender, also known as fiat currency, such as the U.S. dollar.

      Adaptive scaling

      Adaptive scaling is one of the advantages of investing in cryptocurrencies. It means that it gets harder to mine a specific cryptocurrency over time. It allows cryptocurrencies to work well on both small and large scales. That’s why cryptocurrencies take measures such as limiting the supply over time (to create scarcity) and reducing the reward for mining as more total coins are mined. Thanks to adaptive scaling, mining difficulty goes up and down depending on the popularity of the coin and the blockchain. This can give cryptocurrencies a real longevity within the market.

      Decentralization

      The whole idea behind blockchain technology is that it’s decentralized. This concept means no single entity can affect the cryptocurrencies.

      

Some people claim cryptocurrencies such as Ripple aren’t truly decentralized because they don’t follow Bitcoin’s mining protocol exactly. Ripple has no miners. Instead, transactions are powered through a “centralized” blockchain to make it more reliable and faster. Ripple in particular has gone this route because it wants to work with big banks and therefore wants to combine the best elements of fiat money and blockchain cryptocurrency. Whether non-mineable currencies such as Ripple can be considered true cryptocurrencies is up for discussion, but that fact doesn’t mean you can’t invest in them, which is the whole purpose of this book anyway!

      Harvesting

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