In our last post, we covered the basics of blockchain technology. This time, we will dive into the electrifying topic of blockchain consensus mechanisms. First, we will define consensus mechanisms. Then, we will give an overview of the two main ones: proof-of-work and proof-of-stake. Lastly, we will conclude with why this distinction is so important.
A consensus mechanism is an algorithm that allows computers (nodes) to work together and remain secure. As its name implies, it relies on network consensus rather than a trusted third party. Consensus mechanisms solve a dilemma known as “The Byzantine Generals Problem,” described in a 1982 research paper by Leslie Lamport. Imagine a group of generals encamped around an enemy city. The generals must coordinate their attack to succeed, but they can only communicate by passing messages to each other. These messages may be intercepted, falsified, or lost, resulting in mission failure. A single general being corrupt and sending a false message down the line can doom the attack.
A consensus mechanism seeks to solve this problem by requiring each node (general) to participate in a computing exercise to verify each message. Thus, there is no longer a single point of failure. More than half of the generals would have to be corrupt (or hacked) for the system to fail.
Proof-of-work (PoW) is a consensus mechanism that requires nodes in a network to “work” by solving mathematical puzzles to maintain the integrity of a blockchain. It is similar in concept to a website asking you to click on images before logging in to “prove” that you are not a robot. This tiny amount of work required for each try makes it practically impossible for a “robot” to guess your password by trying millions of times.
PoW allows peer-to-peer transactions to occur without the need for a trusted third party. Instead, the “work” needed to maintain the network and its security is distributed across a global computer network. The owners of these computers receive rewards in the form of cryptocurrencies and transaction fees. The act of setting up a group of computers to work to earn crypto rewards is known as “mining.”
Critics of this consensus mechanism point towards its high energy usage. According to the Cambridge Centre for Alternative Finance, Bitcoin mining consumes around 110 Terawatt Hours per year or roughly 0.55% of global electricity production.
Proof-of-Stake (PoS) is a newer method designed to improve upon PoW. For example, instead of requiring miners to spend electricity racing to solve puzzles, PoS selects a “validator” to reward. Validators are chosen based on how much of their crypto they have “staked” or contributed.
PoW rewards people for having better or more equipment. PoS rewards people for owning more of the cryptocurrency. Critics of PoS point out that it results in “the rich getting richer.” However, supporters of it point out that PoW also rewards those with more resources.
The PoS mechanism is significantly more energy-efficient. According to Vitalik Buterin, the creator of Ethereum, moving to PoS will cut the energy consumed per transaction by more than a hundredfold.
Ethereum started as a PoW blockchain and is currently undergoing a transition to PoS. If and when this transition completes, it will be a significant milestone for PoS, as Ethereum represents around 17% of the global cryptocurrency market cap as of 2021.
Besides the environmental considerations, the debate between PoW and PoS may have significant investment implications.
In February of 2021, major car manufacturer Tesla announced that it had bought $1.5 billion worth of bitcoin and would accept bitcoin as payment. The price of bitcoin continued to rise before reaching a peak of around $64,000 in April. Then, in May, Tesla CEO Elon Musk tweeted his concerns with bitcoin’s PoW-driven energy consumption. Within 24 hours, bitcoin’s price fell by around 15%.According to Google Trends, the search term “proof of work vs. proof of stake” reached its peak popularity during this time in May. As of this writing, in July 2021, the price of bitcoin was around $31,000.
While there are other factors at play driving the price of cryptocurrencies, it seems that public awareness of PoW’s energy consumption coincided with a decline in its value. Thus, if mining becomes more energy-efficient in the future, this may bode well for PoW-based cryptocurrency investments and vice versa.
Consensus mechanisms are the backbone of blockchain technology. We hope we have been able to shed light on how they work and why they are important. Please do not hesitate to reach out if we may be of service in answering any of your crypto-related questions.
This article was written by Matthew Lui, CFA, CAIA, Vice President, Investment Research. As a member of Canterbury’s Research Group, Mr. Lui is responsible for sourcing, evaluating, and monitoring traditional, long-only equity managers. Mr. Lui serves as the chair of Canterbury's Global Equity Manager Research Committee and the vice chair of the Hedge Funds Committee. He also sits on the Capital Markets Committee. Prior to joining Canterbury, Mr. Lui was a trader and research analyst at Knightsbridge Asset Management. He received his Bachelor of Arts in economics from University of California, Berkeley. Mr. Lui is a CFA® charterholder and a Chartered Alternative Investment Analyst.