There are many moving parts in the world of cryptocurrency. From blockchains to proof of work, there is a plethora of terminology that can be more than confusing. Let’s try to deconstruct some of that confusion with a basic lesson.
Proof of Work
You’ve likely heard terms such as “Bitcoin” or “crypto.” You get that they seem to be some kind of “money,” or something minimally of value. You can convert, for example, an actual U.S. Dollar and convert it into cryptocurrency.
Consider the transaction much like that of changing foreign money for a vacation. When you go to Europe, you convert your dollars to Euros. It is the money they accept.
Likewise, in the digital world, “crypto” is the accepted form of payment for many products. But, the dollar is truly just a piece of paper, formerly backed by gold (until 1933) and silver (until 1968). Now, that piece of paper, in technical terms, is truly just backed by the United States government. It is accepted as a trade for goods and services but is no longer backed by a physically valued object.
Cryptocurrency is similar. It is a value placed on it in theory. Cryptocurrency is produced via a “proof of work” system. Instead of being backed by a banking system, overseeing or regulating the system, cryptocurrency is backed by proof of work.
People are on the other end of that system. People are solving complex puzzles. These people are called miners (think 1940s gold diggers). In doing so, they are using energy-guzzling machines. These machines require power, or electricity, in order to function.
When a miner solves a puzzle, a new block is formed. Blocks of verified transactions are held in a decentralized ledger, called a blockchain. This is a public ledger. It means many hands are in the pot.
The Cost of Doing Business: Transaction Fees
Nothing comes for free, right? Bitcoin mining is no exception. Work costs money, or why would anyone do it?
The most commonly used blockchain is Ethereum. In order to have a block added, that transaction and validation have a cost. That cost is called a gas price. This is one example of transaction fees (think banking fees but for the digital money world).
When understanding the proof of work concept, often abbreviated as POW in the crypto world, it is ideal to walk through the actual process involved. The bitcoin transactions process has many steps. Here is a breakdown of how that should work:
- Meet Max. Max wants to transfer bitcoins. This means he has some in a virtual wallet. He wants those funds to go to another person. Let’s call her Jane.
- Max must obtain Jane’s bitcoin address. Think of this as her bank account number. If you were transferring physical dollar bills from Max’s to Jane’s account, you would need the bank account numbers.
- Max determines what he is willing to pay for this transaction. Where a bank may say it will cost you $X to move that money, in the world of bitcoin transactions, you name your price.
Thus far the bitcoin transaction includes an input (here, Max’s virtual wallet or source of the bitcoins being moved), an output (Jane’s bitcoin address, where the bitcoins are going), and the amount of bitcoin being moved (the value involved).
4. Max accesses his own private key to send the transaction to the blockchain.
5. The transaction is sent to the closest node on the bitcoin network.
6. The network verifies that the bitcoins are, in fact, are in Max’s wallet.
7. Assuming the bitcoins are there, the transaction heads over the Memory Mining Pools, where it waits for a miner to pick it up in the next block to be made in the blockchain.
8. A miner picks up the transaction, usually to those paying the highest gas price first, and attempts to form the next block. To do so, the miner must solve the Proof of Work, or the puzzle necessary.
9. The first work miners join to solve said puzzle forms the latest block, once the information is verified.
10. Jane can then begin to see the first transfer of bitcoins to her wallet.
As you can see, the entire transaction needs to use proof of work in order to proceed.
Proof of work is the system that, bottom line, requires a not-insignificant but feasible amount of effort in order to deter frivolous or malicious uses of computing power. Makes total sense, right?
Those computing powers may be things such as sending spam emails or launching denial of service attacks.
In Terms of The Bitcoin
The use of a blockchain isn’t something new. The concept was adapted into the world of finances, however, by programmer Hal Finney in 2004. Finney used the idea of “reusable proof of work” using the “SHA-256 hashing algorithm.
Following its introduction in 2009, Bitcoin became the first widely adopted application of Finney’s PoW idea. Unironically, Finney also happened to be the recipient of the first bitcoin transaction.
Proof of work today forms the basis of many other cryptocurrencies as well, not just Bitcoin. It allows for secure, decentralized applications (dApps).
Largely, the use of PoW is a security feature. That proof of work means that there is required mining power. It allows for checks and balances. It prevents one individual or entity from “gaming” the system.
Feel the Power
The term computing power also refers to actual energy. In order for the mining process to use a proof of work (pow system), it takes computers. Miners aren’t actually out there with pickaxes, digging for gold.
Instead, they are working on actual computers. Those computers, as you may well understand, need to be powered with electricity. Many of those against the PoW system claim that more mining power means more use of energy.
Without computational power, miners can’t work. Without that work, the entire PoW system cannot exist. But, is that energy cleanly sourced? How much does the modern computer consume? Questions surely remain, but there are benefits to the PoW system.