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June 24, 2021
THIS WEEK, the price of bitcoin briefly fell below $ 30,000, more than 50% of its April peak of nearly $ 65,000. Investors are worried about a growing regulatory crackdown on cryptocurrency. On June 21, China ordered several state-owned banks and Alipay, a fintech giant, to track and block related transactions. Among other things, regulators are concerned about the environmental damage caused by the mechanism used by Bitcoin to verify transactions and put new coins into circulation, known as Proof of Work (POW). In times of high activity, as seen for much of 2021, bitcoin burns more energy than Argentina as a whole. The glaring inefficiencies of this process also explain why bitcoin payments are slow and expensive, and therefore rare. This has fueled the appetite for alternative mechanisms, the most popular of which is dubbed Proof of Stake (POS). Ether, the second most popular cryptocurrency after bitcoin, is about to switch to it; small rooms already use it. What is POS and can it fix bitcoin issues?
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The raison d’être of prisoners of war lies in that of bitcoin itself. As a decentralized currency, bitcoin does not have a trusted central authority that validates transactions. Instead, it relies on a public consensus mechanism where every block of transactions is validated by someone on the network and then verified by everyone. Miners collect blocks by selecting pending transactions from a pool, ensuring they are legitimate by verifying, for example, that bitcoins are spent by their true owner. To earn the right to add their block to the blockchain, the database that records transactions, miners compete to be the first to solve a complex digital problem using lightning-fast computers. Whoever does is rewarded with new bitcoins. This absorbs huge amounts of energy, making POW both an ecological disaster and a lousy verification method (bitcoin can only process about seven transactions per second).
The POS is an alternative consensus mechanism that distributes rewards based not on who first solves a math puzzle, but on the amount wagered by competing validators. To have the ability to validate transactions, network users must place coins in a specific digital wallet, where this amount will remain frozen until the block of transactions is processed. Instead of paying to those with the most computing power, POS chooses the winners at random, with the probability of being chosen tied to the amount wagered. Unlike POW, which pays miners both with a reward each time they create a new block and a fee per transaction, POS only does the latter. All of this means that the process requires a lot less equipment and energy than POW. Validators have an incentive to keep the network secure: the more they bet, the more they win, but the more they also risk losing if they try to hack the network or validate fraudulent transactions.
But POS also has drawbacks. It is less efficient at putting new money into circulation. It also encourages hoarding, as the likelihood of earning large fees increases in parallel with the amount held in escrow wallets, rather than spent on transactions. This is bad for the availability and liquidity of currencies, which limits its usefulness and makes its value even more volatile. It could also end up concentrating the validation powers in fewer and fewer hands, thus defeating the goal of decentralization. In POW, on the other hand, miners are encouraged not to hang on to their crypto, because in order to engage in the mining arms race, they constantly need fresh, real funds to upgrade their hardware. This unsatisfactory state of affairs has led to a proliferation of hybrid protocols, such as proof of activity or proof of burn. Others, like Proof of Capacity, which rewards users for how much space they have on their hard drives, use different methods. But none of them have yet managed to steal the POWs crown, and with it, bitcoin has lost the top spot.
Dig Deeper: The line between crypto and fiat money is becoming increasingly permeable. Is the financial institution getting closer to bitcoin? Special Report: The Future of Banking
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