What is Proof-of-Work (PoW)?

ResearchSep 02, 2022
What is Proof-of-Work (PoW)?

The absence of central gatekeepers is one of crypto's core tenets. A network of participants verifies transactions added to their blockchain in a decentralized fashion. Consensus mechanisms determine which of them confirm new data for a block reward. Learn more about Proof-of-Work (PoW), the technical foundation of Bitcoin and Ethereum.

Proof-of-Work scheme. Source: Ledger
Proof-of-Work scheme. Adapted from Ledger

Pros and cons at a glance

Thanks to Proof-of-Work, anonymous entities in a distributed network trust each other. It ensures the integrity of new data in the absence of a central authority. This mechanism is highly secure, provides decentralized validation, and lets crypto miners compete to earn rewards for valid blocks.

On the flip side, Proof-of-Work is notorious for slow processing, substantial fees, massive energy use, and costly equipment. Here is a closer look at the principles, benefits, and drawbacks of this cryptocurrency consensus mechanism.

Who invented Proof-of-Work consensus protocol?

Proof-of-Work, which is integral to Bitcoin, was invented more than a decade before Satoshi Nakamoto's white paper. Moni Naor and Cynthia Dwork introduced the concept in 1993, Markus Jakobsson and Ari Juels formalized it in 1999, and Hal Finney adapted Proof-of-Work to digital money in 2004. He proposed "reusable proof of work" for cryptocurrencies based on the SHA-256 hashing algorithm.

What cryptocurrencies use Proof-of-Work?

Bitcoin is the first popular application of this idea. On January 12, 2009, Finney received the first mining reward and BTC transaction — 10 BTC. Subsequently, Proof-of-Work was adopted by other cryptocurrencies, such as Dogecoin, Bitcoin Cash, Litecoin, and Monero. Around 64% of the total crypto market capitalization relies on it.

Understanding Proof-of-Work

Before becoming the first cryptocurrency consensus mechanism, Proof-of-Work was applied to computer networks. It described a system requiring a substantial but feasible effort to prevent power abuse — for example, denial-of-service attacks or network spam.

Bitcoin popularized Proof-of-Work as a foundation for consensus in permissionless decentralized networks. It is still used for validating transactions on a cryptocurrency's blockchain through:

  • Transaction grouping. As users sell and buy digital currency, their transaction data is pooled together into blocks.
  • Constant miners' competition. Miners spend computing power and energy to solve laborious math problems. The first miner to succeed with acceptable proof of computational effort (hash) gets the right to process a new transaction block.
  • Block addition. Every block is added by a single miner. Once the processing is complete, they get native coins — a reward for investing in the hardware and energy.

Security based on computational power

Bank transactions imply trusting the institution to accurately move your money around. If you make a deposit, you expect your account to be credited for the accurate amount. When writing a check, you trust that the bank will debit the amount written.

In the absence of financial institutions, mining and Proof-of-Work ensure transparent and accurate transactions. Miners are facilitators and guardians supporting smooth functioning of the blockchain ecosystem. They are motivated to validate transactions correctly.

Elements of Proof-of-Work. Source: Capital.com
Elements of Proof-of-Work. Adapted from Capital.com

Key aspects of Proof-of-Work

  • Computational puzzle. Also known as CPU cost function, client puzzle, or CPU pricing function, it defines the fundamental asymmetry of this system. While solving the puzzle is laborious, the results are easy to verify for other miners and clients.
  • Built-in incentives. Winning miners get crypto for allocating computational capacity to the network. How many coins they get is gradually changing. The Bitcoin rewards halve every 210,000 blocks, or roughly every 4 years. This event is known as the Bitcoin halving.
  • Proof of work. A block is valid when its production consumes a certain amount of computational power. The term work refers to the competition to solve arbitrary puzzles — a barrier to gaming the system. The winning miner adds the newest batch of data or transactions to the ledger. If other network participants confirm their output, the crypto miner gets their reward.

Since 2009, the reward per block has shrunk from 50 BTC to 6.25 BTC. Peculiarly, the price of BTC has generally corresponded to the halving events. Reducing the number of new coins released into circulation has a deflationary effect.

Hash function in Bitcoin transactions

Once a message is digitally signed, the function produces the final 256-bit hash. A special nonce — "number used once" — is added to the end of the transaction. It influences the hash, ensuring it begins with a particular number of consecutive zeros.

Hash function applied to a Bitcoin transaction. Source: Forkast.news
Hash function applied to a Bitcoin transaction. Adapted from Forkast.news

This deterministic cryptographic mechanism is crucial for Proof-of-Work. Inverse computation is impossible — participants can only check that the data generating the output matches the original input. Any tiny alteration makes the final hash unrecognizable and requires re-mining all subsequent blocks. This is the blockchain's safety net.

Solving for a block requires discovering the nonce. Miners' computers randomly engage in hashing functions until they get an output with the correct minimum number of leading zeroes. For instance, block #660000 mined on Dec. 4, 2020 had the following hash:  00000000000000000008eddcaf078f12c69a439dde30dbb5aac3d9d94e9c18f6.

These long strings of numbers serve as work proof — applied to a given set of data, the function always generates only one hash. The probability of guessing a nonce is as low as one in a billion. This is the cornerstone of secure peer-to-peer processing.

Problems solved by Proof-of-Work consensus mechanism

The purpose of this protocol, despite its name, is not to prove the computational effort. Most importantly, it deters manipulation, eliminating the need for a trusted centralized authority.

Double-spend problem

As cryptocurrencies are non-physical and computer files are easy to duplicate, the same coins or tokens could be spent multiple times. Proof-of-Work prevents double spending. Miners verify the integrity of new transactions before they end up in the distributed ledger. They get rewards for expanding their resources to confirm new blocks.

Network fraud prevention

It is crucial to prevent tampering by network participants so each of them broadcasts valid data. In a centralized environment, their activity would be overseen by a third-party entity. Proof-of-Work uses a hash function instead (see above).

Mining difficulty and computing power

Mining of the next block means it is added to the ledger, which requires a valid hash. If the system accepted just any hash, any miner would be eligible for Bitcoin rewards. The difficulty level turns this task into work, as it rises proportionately to the amount of collective computing power.

This periodic adjustment ensures a new block gets mined roughly every 10 minutes, so the production is stable. The system assesses and alters the difficulty level every 2,016 blocks, or roughly every two weeks. Otherwise, due to the sheer number of mining rigs, the computational puzzles would be solved much faster.

The optimal mining speed is maintained by changing the target hash. A lower target reduces the set of valid hashes, which makes a valid sequence more difficult to establish. Mining the same number of blocks requires more computing resources. The difficulty is directly linked to the total estimated mining power expressed as Total Hash Rate (TH/s).

Rise in mining difficulty between 2018 and 2021. Source: Medium.com
Rise in mining difficulty between 2018 and 2021. Source: Medium.com

Drawbacks of Proof-of-Work protocol

As the first mechanism for crypto consensus, Proof-of-Work has its flaws. Its carbon emissions and rigidity have prompted the Ethereum network to abandon it (more on this below).

Environmental concerns

Proof-of-Work systems have massive computational needs. In 2009, the capabilities of one desktop computer sufficed to mine 1 BTC, according to the New York Times estimates. Today, it would almost certainly find nothing. In 2021, 1 BTC required as much electric power as a standard American home over 9 years. The carbon footprint has been growing exponentially.

Scalability limitations

Scaling of the mining power means buying more computers with advanced software. Not only is the mining equipment costly and energy-consuming, it also requires cooling systems. A build-up of heat can undermine operations and damage hardware components.

Centralization issues

The hashing power of a home PC may reach 100 mega hashes per second (1 million), as opposed to 30 exa hashes per second (1 quintillion) of an ASIC mining farm. Due to the computing demands of the protocol, mining is concentrated in major pools. In the future, a few entities might take over most operations, entailing centralization and security risks.

Expensive participation

The aforesaid costs are prohibitive for some individuals and organizations that would otherwise contribute to Proof-of-Work blockchains. This hinders public participation. However, new miners can join forces — as of now, the biggest BTC mining pools are Foundry USA (focused on large miners) and F2Pool.

Transaction fees

The average transaction fee on the Bitcoin blockchain is $23. It typically rises during bull runs, when more users swarm to BTC. High demand translates into blockchain congestion. While the space is limited, there are more transactions waiting to be accepted.

Bitcoin network users pay miners a fee for their work. Raising its amount lets them get their transactions through faster. It is also possible to cut costs — for instance, by waiting out or using the Lightning Network. This second layer of the blockchain supports smaller and cheaper transactions powered by smart contracts.

Proof-of-Work vs. Proof-of-Stake

While Bitcoin was the pioneer of Proof-of-Work, Peercoin introduced an alternative consensus protocol called Proof-of-Stake (PoS) in 2012. As the name suggests, it requires that validators stake, or lock up, their coins in a smart contract on the network. They confirm transactions without arduous computational work.

As Proof-of-Stake needs less computing power, it is more sustainable and scalable. Ethereum's transition to the protocol (The Merge) is expected to cut its energy demands by up to 99%. Such networks offer faster transactions, lower transaction fees, and modest energy demands. Furthermore, staking is more accessible to the general public, as no costly hardware is required. The only condition is stake proof — that is, coins.

Nodes that let flawed or fraudulent data go through are penalized — they lose some or all of their stake. Yet security is a concern, as participants with the biggest crypto holdings may abuse their power.

Key takeaways

Proof-of-Work is the first crypto consensus mechanism popularized by Bitcoin. It is used for validating transactions and mining new currency. Miners work — expend their computing resources — to solve arbitrary puzzles and receive payment for validating blocks. Complex math problems requiring the hash function prevent anyone from gaming the system.

On the downside, the Proof-of-Work mechanism requires substantial energy and expensive hardware, so it creates a semblance of centralization. The costs prevent more miners from joining in, and most blocks are validated by pools. These and other issues are addressed by Proof-of-Stake — it lets a network verify transactions without laborious mining but raises other concerns.

Disclaimer:

The information provided by CoinLoan (“we,” “us,” or “our”) in this text is for general informational purposes only. All investment and financial opinions expressed by CoinLoan in this text are from the personal research and open information sources and are intended as educational material. All outlined information is provided in good faith. However, we make no representation or warranty of any kind, express or implied, regarding the accuracy, adequacy, validity, reliability, availability, or completeness of any information in this text.

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