Now that you have a solid understanding of some context for what blockchains and cryptocurrencies are, let’s get into how they actually work.
- Consensus Methods
- It’s All Behind the Scenes
- Proof of Work
- Proof of Stake
- Proof of History
- Transaction Speed & Throughput
Consensus methods enable networks to decentralize. These methods are algorithms embedded into the code that enables verified networks of computers to participate in blockchain transactions. They are the absolute cornerstone of every blockchain and they incentivize miners or validators to verify transactions while at the same time making it too expensive to take control of the entire network. If one miner or validator were to overtake the network, they could basically re-write history and front-run any transaction.
Generally, the more computers there are that are mining or validating blocks of transactions, the more secure the network is.
There are dozens of consensus methods with which blockchains verify and settle transactions and they each have their own tradeoffs. Blockchains have attributes that when addressed, make other attributes problematic. Ethereum’s co-founder, Vitalik Buterin, has clarified this concept with the idea of the Blockchain Trilemma. It is a set of three issues – decentralization, security, and scalability – which require sacrifices of one for the sake of the others.
There are plenty of arguments over which is the most secure consensus method but it’s important to remember that crypto is a hyper-evolving technology that, in many cases, can be considered unproven. There are proven aspects of the technology but that doesn’t mean another technology can’t come in and make it all obsolete.
Some skeptics even think quantum computing will make the cryptography behind cryptocurrency obsolete but that is entirely hypothetical. The alternate take is that the security measures behind it evolve alongside advances in technologies like quantum computing.
It’s all Behind the Scenes
By far the most important and widespread consensus methods are Proof of Work (Bitcoin, Hathor), Proof of Stake (Ethereum, Avalanche, Near, IBC chains), and Proof of History (Solana). We’ll break down each of these below. Most chains utilize Proof of Stake to some capacity although many operate with variations or hybrids of the above. To make it even more confusing, Ethereum is in the process of switching from Proof of Work (PoW) to Proof of Stake (PoS) and Solana is a hybrid of PoS and PoW.
Ultimately, the vision is for blockchains to operate as an enhanced version of the internet. You won’t need to understand what consensus method is going on behind the scenes of your favorite NFT or DeFi protocol in the same way that you don’t need to understand the TCP/IP and HTTP protocols going on behind the scenes of every website on the internet.
Proof of Work (PoW)
When using a Proof of Work consensus method, the computers that verify transactions are required to compute very complicated math problems. These computers are called Miners.
Transactions are recorded in a sequential series of blocks that is constantly being updated as more transactions are mined. This method prevents users from double spending the same cryptocurrency as every miner is able to see every transaction that has been made up to the present moment. Mining is an energy-intensive process that requires more energy the more miners are involved. The math problems that these miners have to solve become more difficult as more miners join the network – thus requiring more energy to be expended. The same is true in the opposite direction.
When a Miner has mined a block of transactions (verified them as being true and distributed that truth across the entire miner network), they are rewarded with a token. In the case of the Bitcoin blockchain, miners are rewarded with Bitcoin. The reward size decreases over time, thus introducing more scarcity into the network.
In order for the total number of Bitcoins to change, an entire overhaul of Bitcoin’s source code would need to be implemented. There are many checks and balances in place intended to make changing the code an extremely difficult and arduous process which would essentially require thousands of developers to agree on issues that have caused previous developers to go out and start their own blockchains. It’s unlikely but it is possible. The culture surrounding Bitcoin is another roadblock as Bitcoiners are typically against implementing changes to the protocol.
The last of the 21 million Bitcoin is projected to be mined around the year 2140. It’s up to speculators to estimate how the network will work after all the coins have been mined – some claim it will be done solely with transaction fees being rewarded to miners. We’ll see (or our grandkids will).
The difficulty of the math problems is calculated by Bitcoin’s hashrate. The hashrate measures the combined computational power being used to mine Bitcoin. In 2019, China accounted for over 75% of the global hashrate. This meant that roughly 75% of Bitcoin mining was taking place in China. In 2021, China banned the holding and mining of cryptocurrencies and all the Chinese miners were forced to shut down or move operations to a different country. Because of this dramatic event, the hashrate declined.
As you can see in the diagram above, the hashrate has since improved and even reached all-time highs. Many miners moved to the US which has positioned the US as one of the top locations for Bitcoin miners in the world. It’s unclear if this was anticipated by the Chinese government or if it was an unintended consequence.
This hashrate rally has been occurring during a multi-month drawdown on Bitcoin’s price so it is clearly not a representation of pricing, but rather a representation of the security of the network.
Proof of Stake (PoS)
Ethereum and Solana utilize Proof of Stake although Solana is technically a hybrid Proof of Stake and Proof of History (PoH) network. The computers verifying transactions on a Proof of Stake network are referred to as validators. These validators are not performing the difficult math to earn rewards but rather they are proving themselves as network participants with large stakes in the network. Individual stakers choose to delegate tokens to a validator on the network of that token and are rewarded with a share of the validator’s rewards. Stakers delegate to validators based on certain sets of criteria like their reward share, uptime, and reputation. If you’re staking SOL, you’re doing so through a SOL validator and you’re helping secure the Solana network.
💡 The more validators or miners involved in a blockchain the better.
If a validator has too much sway on the network, they can change the history of the ledger and cause mayhem. To help prevent that from happening on Solana, Solflare has implemented Marinade Finance’s liquid staking product which delegates SOL to a network of over 450 validators, effectively securing the decentralization of the Solana network. Given that Solflare has facilitated over 25% of SOL staking (roughly $30 billion worth at its peak), this partnership with Marinade is rather significant.
Bitcoin is the primary blockchain that utilizes PoW and is somewhat its own thing. Most of the other top blockchains utilize PoS or variations of it.
Proof of History
Solana has introduced a number of novel innovations, namely Proof of History. Proof of History is a mechanism that enables Solana validators to measure time in a new way which allows them to process transactions at unprecedented speeds. The speed and efficiency of Solana can not be overstated.
Essentially, what Proof of History implements is a clock that gives validators and the network a method to tell time without relying on any trusted source. The clock is not measuring absolute time frames as a regular atomic clock would, but rather it is measuring the relative distance between events and transactions. This enables a level of standardization that is not possible elsewhere and gives the network the ability to validate information extremely quickly.
Transaction Speed & Throughput
Throughput refers to the measure of how many actions are completed in a window of time.
Different blockchains form for different reasons and have vastly different speeds and throughputs. Bitcoin was formed to be a peer-to-peer method of exchange but has since become digital gold. Ethereum formed to be an infinite machine. Solana formed to be the fastest and most scalable medium to record state changes.
Bitcoin can handle anywhere from 5-10 transactions per second (tps). Ethereum can handle about 10-30 depending on network congestion but as many of you know – it can be quite costly. Solana, on the other hand, will be able to handle roughly 65,000 tps and that number will theoretically increase as computing power increases. It regularly handles between 2,000-6,000 tps at the time of writing.
Fees are also a fraction of a penny on Solana while Ethereum fees can range $5-200 for simple transactions. For some perspective, Visa and Mastercard – centralized entities with closed ecosystems – can handle about 50,000 transactions per second at their combined peak volumes and they charge vendors anywhere from 1-4% per transaction. This isn’t even accounting for exchange fees that take place when a charge is being done outside of the country that the card came from.
That is all well and good for Visa and Mastercard, but Solana can do the same while being an Interoperable and Immutable open system with far lower fees. It’s an upgrade to traditional payment rails.
Blockchains are like operating systems. Some are built for modularity and some are built to be monolithic. As mentioned in the first few paragraphs of this chapter, blockchains, and cryptocurrencies are hyper-evolving experiments. The goals and vision of blockchains differ as much as the technology does and there are endless arguments on the validity and security of different consensus methods. As a result, new blockchains are popping up every year.
Much of this course includes topics that could be a course in itself. Consensus methods could be many courses. It’s a huge topic that is relevant to developers, entrepreneurs, and investors alike. If you want to invest in or build something on a blockchain, you need to know what’s possible – and consensus methods are what make it all possible.