What is Bitcoin, Blockchain, Proof of Work, and Proof of Stake?
In my previous post, I mentioned Bitcoin. But what exactly is Bitcoin? Bitcoin is a digital currency that is not backed by any country’s central bank or government. It can be traded for goods or services with vendors who accept Bitcoins as payment. Not quite “fake, paperless” money but a store of value.
Bitcoin is powered by a new paradigm shift in the organization, called blockchain. It is an incorruptible ledger that allows users to establish connections without the need for a middleman (third party) and records all transactions in a decentralized database. The system is enabled by a set of public (shared) and private (only visible to owner) keys. Each owner of Bitcoin transfers the coin to the next by digitally signing a hash of the previous transaction. The public key of the next owner and adds these to the end of the coin. (Adapted from the Bitcoin White Paper). The transactions are aggregated and then put onto a block. Each block contains about 2000 transactions with each block containing a unique identifier (a hash). All the blocks form a chain (a blockchain).
Since there is no third party to validate the transactions, another system needed to be created. Miners are the people who validate the blocks and add them to the chain. How it works is like so: Miners solve complex computational challenges for the system for the verifications of the transactions. After they have solved the challenge, they then add the block to the chain. Their reward is the newly created coin that they’ve just mined. Sometimes it is a whole coin, others it is a fraction. Mining requires tremendous computation power, think massive servers, but the payout could be monumental.
I like the think of Bitcoin mining similar to Sudoku. It takes lots of mathematical compute to solve a Sudoku puzzle. Each square in a Sudoku puzzle represents a transaction. When the Sudoku gets solved, it gets stored as a record. In blockchain, the record is a decentralized ledger. The puzzle solvers here represents the miners who are validating the transactions by adding into the Bitcoin blocks. After the puzzle is solved, its quickly checked by other miners. When a consensus is reached that the puzzle is correct, it gets added to the blockchain and the miner is rewarded. It takes a long time to solve the Sudoku puzzle but is easily checked. Bitcoin is the roughly the same.
This type of computation, validating, reaching a consensus, and then adding to the ledger is called a Proof of Work concept. You literally have to prove your work at every step in order for the system to function.
Another idea is Proof of Stake. This requires the user to show ownership of a certain number of cryptocurrency units. The creator of a new block is chosen somewhat at random, depending on the user’s wealth (stake). Blocks are forged in this system. Users who validate transactions and create new blocks in this system are referred to as forgers. Generally, at the launch of new digital currencies, the amount is fixed. Hence, the forgers receive transaction fees as rewards. In order to validate transactions and create blocks, a forger must first put their own coins up. Think of it was putting your holdings into a custodial account. If you validate a fraudulent transaction, you lose your holdings and rights to participate (cannot forge in the future). Once the forger puts their position up, they can partake in the forging process. In theory now incentivized to validate the right transactions since they have their own coins put up.
All of these theories and systems are greatly disrupting how we thin. More blockchain solutions are created serving different problems and markets. I for one would like to see where we go with this.