How Does Crypto Work?

Alrighty, let's talk about how blockchains work and stay secure!

And I know, the technical stuff can be boring, and knowing how things work is stupid - but if you're going to put your money into crypto, or anything really, you should probably have a rough idea of how it’s meant to work. You have probably heard terms like ‘Proof of Work’ and ‘Proof of Stake’ thrown around, but can you name ten ‘Proof of Work’ songs right now? Yeah, I didn’t think so. So do yourself a favor and read on.

One of the most fundamental things about a blockchain, every blockchain, is a way to verify transactions, without relying on a central authority. That's where these different "consensus mechanisms" come in. They're the rules that determine how transactions get approved and added to the blockchain. The most famous ones are Proof of Work (used by Bitcoin), Proof of Stake (used by Ethereum since 2022), Proof of Authority (used by some private blockchains), and XRP's unique Ripple Protocol Consensus Algorithm. Each has its own pros and cons, and as the technology develops, we could see some of these methods being phased out; certain ones being favored over others or brand new ones coming into play.

Let’s start with Proof of Work, because it is the original system that Bitcoin made famous. We’ll be calling it PoW from now on. PoW works like a massive computational race, where miners compete to solve complex math problems. The winner gets to add the next block of transactions to the blockchain and earns some shiny new BTC as a reward. It's incredibly secure - attacking Bitcoin would require more computing power than exists in some small countries. But the problem with PoW is the amount of energy it needs. All that computing burns through insane amounts of electricity. We're talking about Bitcoin using more power annually than some countries. 

Then there's Proof of Stake, or PoS, which Ethereum switched to in 2022. Instead of miners burning electricity, validators are chosen based on how much cryptocurrency they're willing to "stake" or lock up as collateral. The more you stake, the better your chances of being selected to validate transactions and earn rewards. It's like a lottery, and if you buy more tickets, you get better odds. The biggest advantage of PoS compared to PoW is the energy usage. It uses about 99% less energy. Transactions are also faster and cheaper. But like PoW, it's also not perfect. Critics of PoS argue that the system favors the rich (those who can afford to stake more) and hasn't been tested as thoroughly as Proof of Work over time. That’s PoS.

Then there is Proof of Authority, which takes a completely different approach. Instead of being open to anyone, only pre-approved validators can verify transactions. This makes it lightning fast and extremely energy efficient, but at the cost of decentralization - which is kind of the whole point of cryptocurrency. It's great for private business blockchains where you know and trust all the participants, but not so great for public networks where trust needs to be distributed.

Then there’s XRP's ‘Ripple Protocol Consensus Algorithm’, which is another different system entirely. It uses a rotating group of trusted validators, who vote on transactions until they reach consensus. This lets XRP process transactions in just 3-5 seconds with fees that are fractions of a penny. It's perfect for moving money between banks quickly and cheaply, which is why many financial institutions are interested in it. But like Proof of Authority, it's more centralized than Bitcoin or Ethereum.

Now, as an investor, do you need to have a favorite? Should you be investing in one technology over another? Well, it depends what you care about - but more than anything it’s just good to know how this stuff works.

If you want maximum security and don't mind the energy use, Proof of Work is still king. If you care about sustainability and speed, Proof of Stake looks pretty good. For private business networks, Proof of Authority works well. And for fast, cheap payments between institutions, Ripple’s protocol has big advantages.

The future will likely see a mix of these systems coexisting, each serving different needs. It’s also entirely possible that some systems will just fade away completely as the technology evolves. I mean, given the slow speed of PoW, you’d think most developers would build on something else. These technologies are also being upgraded when possible too! Ethereum's move to Proof of Stake shows that even major blockchains are willing to change their fundamental technology, if and when better options emerge. 

Do you need to bet the house on one particular technology? No, but again, know what your money is going into!