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Last time, I began a series of posts attempting to make blockchain and cryptocurrency a bit more palatable and understandable for those who aren't familiar with or are new to the space. My goal is to explain these technologies without getting into complex financial or technical jargon, which can often hinder understanding.

I left off that article with these questions: How are cryptocurrencies obtained? How do we get our hands on it? How do we participate in this burgeoning technology?

Let's start with the first one.

3 Main Kinds of Crypto Blockchains

To begin learning how cryptocurrencies are obtained, it's important that we understand how the different blockchains come to agree on what new transactions go onto the list mentioned in the previous post (what is called a distributed ledger). What follows is a description of the main three kinds, though there are more. You may have heard of these terms before, as they are not all native to blockchain.

Proof-of-Work

This is the most popular way current blockchains which produce cryptocurrencies come to agreement (or consensus). It's really easy to start getting into jargon, so I'll try to explain it as simply as possible.

Proof-of-Work is like a competition between different people in the network. They compete by spending computing power to figure out a string of numbers and letters, called a hash. Attached to this string are the transactions that will be recorded next on the chain (in addition to all the previous transactions). Generally, one of the participants will figure out the hash (thus proving their work), the network will approve the transactions, and then move onto the next ones.

The competitive aspect here is a little bit weird, because no one really knows when their computer will figure out the hash, since the hash is semi-random. So, for the most part, people pool together with others to increase the chance they will be the ones that figure it out. Then, the reward is (presumably) distributed among the various participants.

What reward? The cryptocurrency token, of course! The participant who figures out the hash is rewarded a certain amount of the native token of the network (e.g. Bitcoin network rewards Bitcoin). This is why the process is often called 'mining'. It's like you're a miner in a cave looking for gold. You don't know where the gold is, but if you get a bunch of your friends together, you can probably find that gold faster than that poor individual working by himself.

This inevitably leads to a race to see who can get the bigger group to figure out the hash for transactions. And this race has two main results.

First, as more and more computers are added on to participate, it spreads the network wider. This is a good thing. It's often why Proof-of-Work blockchains like Bitcoin are said to have a self-induced incentive. If I want to get the token, I will want to participate in a network. I am also incentivized to make the network (or at least my group in it) the biggest one, so I have a greater chance of getting the token. Thus, I invite others into the network, and the incentives repeat for them. As this is going on, the network continues to decentralize with more participants being added on.

Second, however, it leads to an increase in the energy required to maintain these systems on the network. As the system naturally increases in size, it consumes more and more power to continue the work. This power consumption is, obviously, not really good for the environment. To illustrate how bad it's gotten, the Bitcoin mining network now requires as much electricity as and has a carbon footprint like that of entire countries.

Proof-of-Stake

With the power consumption problems of Proof-of-Work (as well as a few other problems I won't mention here), a new method was surmised to combat it. Instead of solving complex hashes to obtain more tokens or coins, participants in a Proof-of-Stake system instead hold the native coin in a sort of vault. The more coins held in that vault, the higher the chance that vault will be able to validate the next transactions. People who hold (or stake) in that vault are rewarded in interest of that same coin depending on how much they put in. Thus, the more they put in, the more they will earn of that coin.

This is a bit like how financial and banking systems work (or at least, they used to). For the most part, when we put money in a bank, especially in a 'savings account', banks will offer a small bit of interest, depending on how much you have with them. Generally, the larger the interest, the more people are incentivized to keep their money with the bank. In the same way, in Proof-of-Stake systems, people are incentivized to continue the same network effect by locking their coins in it so as to earn more.

Like Proof-of-Work, there are upsides and downsides. The main upsides, of course, is that it avoids a lot of the problems the Proof-of-Work systems have, while maintaining most of their positive aspects. The tokens in these systems are also often used in other ways, such as voting and governance. However, there are a few issues that are a bit more unsure.

A participant that has staked 51% or more of the total number of coins has incredible power to change the system as he or she sees fit. Some argue that it would be unlikely that this person would become a bad actor, because such a person would be incentivized to keep the system running securely so as to not lose the value of their coins. I don't think much of this argument. First, it assumes there are people who don't just want to watch the world burn. But, more importantly, it also assumes that there is a positive correlation between the increasing value of an item and its utility. Which leads to the next potential problem.

In a Proof-of-Stake system, users are incentivized to keep their coins in the vaults, rather than spend or use them. It's actually a problem for cryptocurrency in general, but users in these systems won't really want to do anything with the coins other than hold them. If that is the case, then the original utility which blockchain and crypto were built upon (a source of transactional currency not tied to centralized intermediaries) is completely lost. If I would rather hold onto my coin than spend it on goods and services, then we are back with the same problem of needing to deal with fiat. And so, it seems Proof-of-Stake is not so much a solution to real-world problems as it is just to the problems of Proof-of-Work.

Federated Byzantine Agreement

This is a third category of blockchain that a (currently small) niche of cryptocurrency are based on. On the surface it's pretty simple. A group of participants come together to agree on what transactions are valid and invalid, just as the others. However, dipping one toe past this often results in a sudden rush of jargon and complexity that results in a lot of confusion (at least this was the case for me). I'll try to explain it a little bit more simply.

Imagine you're with a group of people—friends as well as friends of friends—and you're all trying to decide which of two restaurants to go to for dinner (wow, such a quaint idea in this COVID-19-ridden era). The problem is, you only know a few of these people, and it is likely that not everyone has the same idea of what good dinner food is supposed to be. How do you arrive at a decision that everyone can agree on?

The solution is actually a very human one. You trust your friends, and only your friends. Of course, your friends may trust people who are not your friends, but as long as you trust your friends, you shouldn't have a problem with whom your friends trust. Within the many circles of trust that would result, there would eventually be agreement on whom not to trust, for the sake of the majority.

In the same way, in a Federated Byzantine Agreement, each participant chooses which other participants it trusts. As the number of participants increase, the variation between who is trusted by whom also increases. This, once again, decentralizes the governance so that no single person or entity could control the entire network. Most of these kinds of blockchains require a large majority to agree before moving forward. So what's to stop one or several untrustworthy people to participate and mess the whole process up, or at least make it stop for a while?

Unlike Proof-of-Work and Proof-of-Stake, most blockchains built on Federated Byzantine Agreement have no rewards for its various participants. When you participate in the network, you are doing it because you believe that simply being part of validating the next transaction is a worthwhile task. This heavily de-incentivizes any malicious actors, as committing to any kind of spam attack or untrustworthy participation only wastes your own time. For those who are curious, Ripple's CTO, David Schwartz, has an excellent lecture on this.

But, to put it plainly, it would be as if, in our group deciding which restaurant to go to, one member just decided to start adding more options, or act crazily, or attempt to stop us from going to a restaurant at all. The group may at first humor him, but eventually, we would just ignore or leave this person. Whether or not he learns to behave well enough to be part of our group hangouts is none of our business. In fact, we don't even care, and never again invite him to our parties.

What We've Learned So Far

It may seem like I am biased towards a particular style of blockchain, but I actually think there are advantages and disadvantages in each one.

Proof-of-Work has the advantage of being self-incentivizing. Each part of participating in the network incentivizes both its growth as well as decentralization. Proof-of-Stake corrects the energy problems of Proof-of-Work, and also incentivizes people to hold or stake their coins, rather than use them, and thus, increasing the value of those tokens. Cryptos built on Federated Byzantine Agreement do away with all of those financial incentives, and instead touts a system that is robust and almost tamper-proof.

Ok, wow, I keep thinking that each of these parts are going to be nice short summaries, but I seem to always write a lot more than I intended. So I'll once again be answering the other questions in a subsequent post. Hope it's been interesting so far, I'll see you in the next one!

Header Image credit to Pixabay.