Consensus mechanisms are a system used by cryptocurrencies like Bitcoin and Ethereum to validate transactions and secure the underlying blockchain. Consensus mechanisms help determine the legitimacy of transactions, govern the blockchain, and provide trust and security within the blockchain network.
How do consensus mechanisms work?
All blockchain networks of cryptocurrencies operate using a consensus mechanism. It is a system followed by users of the blockchain network to agree on the validity of transactions. This system ensures that all valid transactions are recorded on the blockchain and that every version of the blockchain contains all valid transactions.
Note: The consensus mechanism is extremely important in a blockchain network. It affects how transactions are verified, the amount of energy consumed, network fees, transaction speed, and other details of the currency and network applications.
The computers that verify new transactions on most blockchains are called miners. In the proof-of-work protocol, these miners compete against each other to validate the next block of transactions. The winning miner receives attractive mining fees paid by those sending transactions on the network.
The consensus mechanism ensures that all miners agree on the next block of transactions and distribute information in each new block to all other miners. Anyone can download a copy of the blockchain on their device as a “node.” Every copy of the ledger matches exactly. The consensus mechanism guarantees ongoing agreement about which wallet holds which assets.
Examples of consensus mechanisms
For example, if you purchase Bitcoin and transfer it to your cryptocurrency wallet, everyone must agree that you own that Bitcoin. If they do not agree, your currency would be worthless. The first consensus mechanism was the “proof-of-work” (PoW) method for Bitcoin. It required network approval (in a unique hash) for every new block added to the chain with each transaction. This validates new transactions and ensures agreement on previous transactions.
While proof-of-work supports the largest cryptocurrency, Bitcoin, it is not the only way to operate a cryptocurrency network. The most important consensus mechanisms used today fall into several main types:
- Proof of Work: Miners compete in proof of work with each other to validate the next block of transactions and earn a reward. It is an energy-intensive consensus mechanism but provides a high degree of trust.
- Proof of Stake: In the proof-of-stake mechanism, those who hold the largest stake of the network’s currency agree on new blocks. This consensus allows for faster and cheaper transactions. It rewards those with the largest stake in the network for their continued participation.
- Proof of Authority: Proof of authority is not very common but has a unique form. It is used by private companies or organizations that employ blocks created by trusted sources that have special permissions to access the network. Guarantees rely on reputation and authority instead of public consensus as seen in other mechanisms.
- Delegated Proof of Stake: Delegated proof of stake is a variation of the proof-of-stake mechanism where users who stake their coins vote on a number of delegates to create new blocks.
- Proof of Capacity: Coins that rely on proof of capacity use the available hard drive space on a computer for decentralized block verification and creation.
- Proof of Activity: The proof of activity consensus mechanism is a hybrid between proof of stake and proof of work where miners seek to leverage the strengths of both systems.
- Proof of Elapsed Time: The proof of elapsed time mechanism uses a random timer that operates independently at each node to assign block verification to a miner.
- Proof
On burning: In the mechanism of proof of burn, consensus is achieved through periodic burning of coins by miners, which is the process of removing the specified currency from circulation. This is accomplished by verifying new transactions and preventing inflation.
If you are investing in a cryptocurrency, it is good to know what type of consensus mechanism is used and how it works.
Note: Ethereum transitioned from its original consensus mechanism based on proof of work to a proof of stake consensus protocol in September 2022 through an upgrade called “The Merge.”
Advantages and Disadvantages of Consensus Mechanisms
Advantages
- Forms a fundamental agreement for the cryptocurrency market.
- Creates a secure environment.
- Anyone can participate.
Disadvantages
- Can be expensive in terms of energy.
- There may be a potential for attacks.
What Does It Mean for Individual Investors?
Understanding how your cryptocurrency works behind the scenes is crucial, as different mechanisms lead to varying costs and transaction times and may affect long-term usability and valuation of the currency.
If you are investing in Bitcoin or any other cryptocurrency, it is beneficial to take some time to read how it works. If you trust the consensus mechanism, you may be able to trust the currency. If not, it is better to invest your money elsewhere.
If you are interested in mining or running your own node, it will definitely be beneficial to understand the consensus mechanism that the blockchain operates on. This mechanism will determine the investment you need to make to start mining, whether you have a successful chance at mining or not, and the rewards you might receive.
Thank you for your feedback!
Sources:
KPMG. “Consensus: Immutable Agreement to the Internet of Value,” Pages 2-3.
Bitcoin.org. “Frequently Asked Questions.”
Sunny King and Scott Nadal. “PPCoin: Peer-to-Peer Cryptocurrency With Proof-of-Stake.”
Microsoft. “Ethereum Proof-of-Authority on Azure.”
Cardano. “Delegate Your Stake To Build The Network, Earn Rewards, and Become Part of the Cardano Journey.”
Signum. “Proof-of-Capacity Plus.”
DeCred. “Overview.”
Mike Bowman, Debajyoti Das, Avradip Mandal, and Hart Montgomery. “On Elapsed Time Consensus Protocols,” Page 2.
Slimcoin. “Slimcoin: A Peer-to-Peer Cryptocurrency With Proof-of-Burn,” Page 1.
Ethereum.org. “The Merge.”
Digiconomist. “Bitcoin Energy Consumption Index.”
MIT Media Lab: Digital Currency Initiative. “51% Attacks.”
Source: https://www.thebalancemoney.com/what-is-a-consensus-mechanism-5211399
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