Cryptocurrencies use consensus protocols in order to maintain a shared state across all participants in a distributed, permissionless network. Consensus protocols define the rules by which coins are issued to participants who contribute to the security of the ledger. This system provides economic incentives for users to follow the rules of the protocol and also provides a mechanism by which cryptocurrencies can be transparently issued to a global user base. Each unique consensus protocol comes with different trade-offs for who is able to participate in the process, energy usage, and profitability. This post discusses the major consensus protocols in use today and the pros and cons of each option.
Proof of Work (ASICs)
Bitcoin Core and many alt-coins use Proof of Work in order to achieve consensus. Over time, companies have built specialized hardware (referred to as ASICs [application-specific integrated circuits]) that are customized for efficient calculations of the cryptographic puzzles used in these protocols. Users who attempt to mine on general purpose compute hardware will expect to spend more money on their electricity bill than they would receive in rewards for securing the network, and a rational economic actor will only mine using an ASIC that has a positive expected return over a reasonable timeframe.
Mining costs can be broken into two categories: capital expenditures (upfront costs of hardware used to participate in the protocol) and operating expenditures (ongoing costs to operate the hardware). Bitcoin is permissionless in that anyone is able to participate and use the network, but it has real barriers in who is able to participate fully through mining. As mentioned previously, only those who have access to ASICs will have the opportunity to mine Bitcoin profitably, and this severely limits full participation in the network.
Bitcoin ASICs are available for public purchase, but they have both high capital expenditures and high operating expenditures (in the form of ongoing electricity costs). The high capital costs prevent those with less than ~$10,000 USD from purchasing an ASIC miner, and the high operating costs force miners into areas with low electricity costs. The result of these forces is that full participation in the Bitcoin network is reserved for those with sufficient capital, risk tolerance, and access to low electricity costs.
Mining Bitcoin is highly efficient and the expected rewards are a small percentage higher than the operating costs for most ASICs, meaning that miners do not end up earning a large amount of profit for their services. This makes the distribution of Bitcoin equitable, in that no actor has access to Bitcoin at a significant discount to market rates. As the price of Bitcoin increases or decreases, miners may turn on and off additional ASICs of varying levels of efficiency, or operate in areas with higher or lower electricity costs, and the profit margin is squeezed towards zero.
Proof of Work (ASIC-resistant)
Monero and other alt-coins have taken issue with the fact that many users are unable to fully participate in the Bitcoin consensus process and have generated ASIC-resistant Proof of Work algorithms in response. These protocols allow average consumers to mine on general purpose hardware and provide no incentive for individuals or companies to produce specialized hardware for mining.
The end result of an ASIC-resistant Proof of Work function is that a larger percentage of users are able to participate in the consensus process. Users can leverage their existing CPUs and GPUs to mine, removing the need for capital expenditures. If they do not own a computer, the cost of acquiring a modern desktop that is able to profitably mine an ASIC-resistant Proof of Work algorithm is an order of magnitude lower than the cost of acquiring an ASIC for mining Bitcoin. The Proof of Work process still requires a significant amount of electricity, which will drive network participation into areas with lower electricity costs. Mining Monero and other ASIC-resistant cryptocurrencies is efficient, meaning that profit margins are low and that coins are distributed to participants at near the cost of production. This can be viewed as an equitable issuance.
Proof of Stake
Ethereum 2.0 and many other alt-coins have moved to Proof of Stake in order to reduce the electricity usage and operating expenditures of securing the network. In order to participate in a Proof of Stake protocol, nodes must lock a certain amount of the coin for some defined period of time. In exchange, these nodes are able to compete to create new blocks and earn rewards for their service.
This system requires a large upfront capital expenditure in the form of the purchase of the coin required to stake. It is worth noting that there are staking pools available to those without sufficient capital to stake as an individual, and for reward smoothing. Proof of Stake has very low operating expenditures, meaning that the local cost of electricity is not a barrier to participation in these consensus protocols. The sole requirement is the purchase of the coin(s) for staking and the risk appetite to stake this coin for some minimum period of time.
In a Proof of Stake consensus model, the wealthiest holders of the coin receive outsized rewards proportional to the amount of coin that they stake relative to all Proof of Stake participants. As the wealthiest few gain disproportionate rewards for their stake, a positive feedback loop can be triggered as they add their new block rewards to their stake.
Proof of Stake systems, in addition to incentivizing the consolidation of wealth, are providing rewards for behavior that has minimal or no operating costs. The benefit of such a system is that the electricity costs of running and securing the network is minimal, but it also leads to a system where new coin distribution is not directly related to the cost of production. Proof of Work miners must sell most of their coins in order to pay their electricity bills, which is not the case in Proof of Stake protocols. New coins are issued based only on capital expenditure and risk in a Proof of Stake system, and block winners have no immediate need to sell coins in order to pay their operating expenditures.
Proof of Space & Time
Chia Network introduced a new consensus model referred to as Proof of Space & Time. This protocol provides rewards to participants based on the amount of storage space that they dedicate to the network relative to all other members of the network. This system will tend to favor those with low-cost (overprovisioned/underutilized) storage as these individuals or companies will have the lowest capital expenditures.
The operating costs of securing the Chia network are minimal compared to Bitcoin and other Proof of Work cryptocurrencies, creating a unique system that leverages low capital expenditure consumer hardware and low operating expenditures. The difference between Proof of Space & Time and an ASIC-resistant Proof of Work protocol is that Proof of Space & Time has lower operating expenditures and will be more equitable to participants regardless of their local electricity costs.
It is likely that as coins using this consensus protocol mature, the operating expenditures of farmers will be pushed towards the expected rewards for farming, leading to a system that is similar to ASIC-resistant Proof of Work coins. If the operating expenditures are significantly less than the expected rewards for securing the network, users with unutilized storage space will be incentivized to commit their storage space to the network until the point where the profit for farming approaches zero.
Overall, I believe that Proof of Space & Time will produce a similar level of fairness of coin distribution compared to ASIC-resistant Proof of Work.
Pre-mines & ICOs
None of the above analyses take into account pre-mines or ICOs, which are common in many cryptocurrencies besides Bitcoin, Monero, and a small handful of other projects. Pre-mines and ICOs typically provide a large amount of the coin to a single centralized party which is responsible for the bulk of early protocol development. Investors have provided an economic incentive to development teams and businesses in exchange for their time, with an expectation that the value of the coin reward will exceed the cost of their investment.
Pre-mined coins have an initial capital expenditure associated with the investment, but no operating expenditure. These coins can be profitably sold by the investor at rates below the cost of new coin production, introducing a risk to miners that a critical participant in the network may sell the coin at a rate which is profitable for the investor but forces the miner to cease mining or to operate at a loss.
No single consensus protocol is perfect, and each introduces unique trade-offs. Based on the ability for the most individuals to participate fully in the network, it seems to me that ASIC-resistant Proof of Work and Proof of Space & Time offer the most opportunity for decentralization. These systems provide opportunities for a wide swath of participants to earn coins at near the cost of production.