Disclaimer: I’m not a crypto expert. Please feel free to correct me in the comments.
Proof of work
Proof of work describes how new cryptocurrency coins are created, how cryptocurrency transactions are validated, and it determines how quickly new cryto coins are created. For this article, we’ll discuss proof of work in terms of bitcoin, however there are many other proof of work cryptocurrencies.
At a high level, to generate, or “discover”, new bitcoins, computers do puzzles that generate hashes. Hashes are long strings of characters, like this “81019284c2f9615e20a6825c…”. Once a computer running the bitcoin software has successfully generated a hash, called “mining”, the hash is checked to see if it happens to be a valid bitcoin. Sometimes it is, but most of the time it isn’t.
The work done to create the new hash also has the important side-effect of validating transactions on the blockchain. In addition to potentially generating a new block, miners are paid transaction fees to validate transactions. At some point all 21 million bitcoins will have been mined and no more will be created. At that point, transaction fees will be the sole incentive for miners to continue validating transactions.
To modulate the speed of coin creation, the difficulty of the work that’s necessary to mine a bitcoin block automatically gets adjusted to be more difficult when miners generate hashes faster. Conversely, the work is adjusted to be easier if the overall rate of coin creation decreases. For example, the difficulty decreased recently when China banned bitcoin mining and lots of mining computers went offline.
So when you generate a new bitcoin, you’re “proving” that you did the work to create it. This is what allows bitcoin to be decentralized–anyone can create one if they do the work, no one can create one without doing the work.
Some people consider the energy used to create new bitcoins to be wasteful. I won’t try to argue for that one way or another, but because of this, many other types of cryptocurrencies use other types of proofs to create new coins. The most popular alternative to proof of work is what Ethereum 2 uses, which is called proof of stake.
Proof of stake
Proof of stake also describes how some new crypto currency is created. The main benefit is that it uses significantly less energy.
For proof of stake to work, an initial quantity of the cryptocurrency has to be somehow distributed to a lot of people first. This process, which we’ll call bootstrapping, can happen in any number of ways. For example, the cryptocurrency can be given away or, in the case of Ethereum, it can be mined using proof of work for several years, then switched to proof of stake later.
In some proof of stake cryptocurrencies, no new coins are created in the future. Proof of stake is only used to validate transactions being added to the blockchain. I’ll explain how that works shortly.
Once the cryptocurrency has become proof of stake, if the currency does create new coin, they’re generated without the requirement to generate hashes by solving puzzles. The newly created coins are instead given to everyone who already holds some of the cryptocurrency as long as they’ve “staked” the currency.
To stake the currency, you have to lock it so it can’t be spent or transferred for a specified period of time. Then, when new coins created, anyone who has staked coins will automatically get more coins in an amount proportional to the amount they have staked.
For example: If Bob stakes 10 blogcoins, a fake proof of stake currency, and Maria stakes 20 blogcoins Bob will get 1 new blogcoin and Maria will get 2. In the end, neither is richer or poorer relative to each other than they were before. They just have a larger number of coins.
If neither Bob or Maria gain anything, why create new coins at all? It’s mostly to increase the total number of coins. If you want to sell 20 people a slice of a really big pizza that’s only sliced in 10 pieces, you’d need to cut each slice in half first to “create” 20 slices. You’re not generating more pizza out of thin air, you’re just making it possible to distribute the existing pizza to more people.1
The other function of staking is, as mentioned above, to verify transactions. When you stake your blogcoins, you’re saying “I’m going to validate this block of transactions in exchange for a fee. If I falsely validate it, I understand that the blogcoins I’ve staked will be taken from me. If I validate it correctly, in addition to not losing my staked coins, I’ll get a small reward for doing the validation.” Staking is a way to incentivize good behavior.
Just like energy use is the downside of proof of work, proof of stake’s downside is that it’s less proven in the real world and, as such, potentially less secure. It also could be that it staking results in less liquidity since the incentives to keep your coins staked is very high.
So, that’s a high level summary of why proof of work and proof of stake are different. There’s much more to be said on the subject, but for now, I’ll leave it at that.
1 Because of the way staked coins are distributed, it isn’t inflationary in the same way as a fiat currency like the US Dollar. When new dollars are created they’re not distributed proportionally to everyone who already has dollars. The recipients of the new dollars are the winners, and everyone else loses because the dollars they’ve saved decrease in value.