Proof of Work Mechanism in Cryptocurrency

Investors who are new to cryptocurrencies tend to find the entire ecosystem confusing and deceptive. When investors try to educate themselves on topics related to cryptocurrencies, they feel like they are attending more of a technical subject course instead of learning about finance. This is the reason why traditional investors have been avoiding cryptocurrencies for a long time. However, there is also a series of investors in the market who are no longer afraid of technology. The new-age investors are both tech-savvy as well as financially savvy. With the increase in the rate of global acceptance for cryptocurrencies, it is now becoming mandatory for every investor to have a basic understanding of the technical concepts which underpin the cryptocurrencies network.

In this article, we will have a closer look at the concept of “proof of work” which underpins any blockchain-based cryptocurrency system.

What is a Consensus Mechanism?

First, we need to understand that blockchain systems are very different from any other systems which we already know. Almost all computer systems in use today are centralized systems. This means that the responsibility of maintaining the database lies with a central authority. For instance, if party A and party B transact using Bank of America, then their information is stored on the Bank of America servers. Bank of America would be in charge of ensuring that the integrity of the system has been maintained.

However, in the case of Bitcoin, a central authority does not exist. Hence, A and B are transacting without any designated authority keeping a record. Hence, record keeping can become extremely difficult. Blockchain solves this problem by decentralizing record keeping. This means that instead of one bank maintaining records, every participant on the network has their own copy of records. Now, since there are millions of people who have a copy of the same record, we need a system to make sure that all the copies are updated. This mechanism which ensures that all the participants on a blockchain network have the exact same record is called a consensus mechanism.

The Problem of Double Spending

Now, since we know what a consensus mechanism is, we also need to know why it is required. If we consider the above example, when A and B transact using Bank of America as the intermediary, the bank deducts money from the account of A and adds it to the account of B. It needs to be understood that money is deducted as soon as the transaction is made. However, in the case of blockchain, since the records are distributed, it could be possible for A to spend the same money twice before the records on the blockchain get updated. It is for this reason that a consensus mechanism is required. The consensus mechanism basically puts each transaction to a vote. All the participating computers vote based on whether the proposed new record matches with their copy of the records. Using this technique, the problem of double-spending can be eliminated from cryptocurrencies. This is what ensures that the value of the currency is maintained since it cannot be counterfeited easily.

How Does Proof of Work Ensure the Integrity of the Network?

As soon as a new block of transactions is placed on the network, miners i.e. other people on the network who provide computational power start validating it. They have to validate the transaction by solving a sequence of complex mathematical problems. These mathematical problems are intentionally made difficult. If the problems are too easy, the security of the network would be at risk. However, if the problems are too difficult, then the processing time for transactions would be too large. Amongst the various miners trying to solve the problem, the first one to be able to do so submits proof of work. This proof of work is rewarded in the form of more cryptocurrency. Other miners also validate the proof of work submitted. In the end, the consensus of the network is gained and the integrity of the network is maintained.

Problems With the Proof of Work Mechanism

The proof of work mechanism is most popular within the cryptocurrency community. This is because this is the method used by Bitcoin which accounts for over 50% of all cryptocurrencies used worldwide. However, there are significant problems with this mechanism.

  • Firstly, experts claim that the mathematical problems which need to be solved before adding transactions to a blockchain are completely arbitrary and even useless. They do not have any utility in day-to-day life apart from being used to secure the network. Many believe that the proof of work system is wasting the computational power present today.

  • Secondly, the proof of work mechanism has been widely criticized for consuming large amounts of electricity. The equipment required in order to execute the proof of work mechanism is specialized and consumes large amounts of electricity. It has been alleged that this equipment has consumed more electricity than in some countries like Switzerland and Hungary. Since electricity is a finite resource that needs to be consumed wisely, the proof of work mechanism has faced significant criticism from environmentalists.

The bottom line is that proof of work is a complex but necessary mechanism that is central to the functioning of the cryptocurrency market. Over time, other mechanisms such as proof of stake have also been introduced. However, proof of work is still the most widely used mechanism.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to and the content page url.