In a centralized financial system the banks validate transactions. They check if you have the funds available and then send the money and update the account balances. But if there is no central authority, a mechanism is needed to validate transactions and achieve agreement between all the nodes on a decentralized network. A protocol is required to keep the network secure and stop malicious actors or groups taking over the network and making dishonest changes to the ledger and account balances.
There are two main block-chain protocols for achieving this, Proof of Work and Proof of Stake. These protocols are algorithms or rules that dictate how the thousands of nodes on the network agree on the state of the network. They determine how transactions are validated, how a new block is added to the chain and how the ledger is updated. All the functions which are usually performed by a centralized authority like a bank, are performed by these consensus protocols.
The consensus algorithm used by bitcoin is called Proof of Work. This protocol uses computers to solve complex cryptographic equations in a process called mining. Miners compete to solve the equation. The first miner to solve the cryptographic puzzle broadcasts it to the entire network, adds the next block to the chain and wins a block reward paid in bitcoin. Solving this puzzle can only be done by brute force, so it takes a lot of computing power or work.
When the price of the currency rises, more miners are motivated to join the network and try and solve the puzzle to gain the block reward. The more miners on the network, the more secure it is since it takes more computing power to gain control of the network. This large requirement of power or work makes it impractical, or unprofitable to attempt to tamper with the block-chain ledger.
The alternative to Proof of Work is called Proof of Stake. With this protocol owners of the cryptocurrency lock up their tokens to validate the transaction. They put their coins at stake to secure the network. The system still uses a cryptographic equation but the mechanism to decide who adds the next block to the chain is different.
In Proof of Stake the winner is selected based on how many tokens they have staked and how long they’ve had their tokens staked. Which means participants are rewarded according to how much they have invested in the network. Once the winner has validated the latest block, other validators confirm the block is accurate. Once a threshold of confirmations is reached, the network updates the block-chain. All the participants receive a reward in the native cryptocurrency in proportion to their stake.
Each system has its own advantages and disadvantages. While some people will argue one is better than the other, it’s difficult to make that comparison. While Proof of Stake is better for energy consumption it’s mostly untested. Bitcoins Proof of Work has seen a decade of testing with no failures. But no one anticipated bitcoin becoming so energy intensive, the specialized ASIC mining devices didn’t happen until years later. As the cryptocurrency market develops and expands, there are probably problems and their solutions we haven’t yet anticipated.