Blockchains are amongst the most groundbreaking innovations of the past decade. Essentially, a blockchain is simply a database that can be used to store information. In the context of blockchain technology, this information revolves around blockchain transactions in particular. Unlike conventional databases, the relevant transaction data is not selected by a few entities or a single point of control and stored centrally.

Blockchains are, by their very nature, decentralized. This means that they have a number of network accounts – i.e. computers, which are known as “full nodes” in technical jargon. Together, these have control over the blockchain. What this means in practice is that each full node has a copy of the current blockchain, so that all network participants always know exactly what units (i.e. cryptocurrencies) of this blockchain belong to whom – in other words, there is always consensus about the activities occurring in a blockchain.

But how does this mutual consensus come about? And how can it be continuously maintained? This is where the consensus mechanism, which is inherent to every blockchain, comes into play. It is a key component of this technology and helps to guarantee the integrity and security of a blockchain network.

Consensus mechanisms: the engine in every blockchain

The specific consensus rules of a blockchain determine its consensus mechanism, which is also occasionally referred to as a consensus algorithm. But what consensus is established by a consensus mechanism? As the name “blockchain” implies, data is stored in this decentralized database in “blocks”, which are continuously strung together in the form of a “chain”. It is this transaction data sequence, lined up in blocks, that the network nodes of every single blockchain must reach a consensus on.

A consensus mechanism determines what transaction data is gathered in blocks and at what intervals it is added to the blockchain. As an incentive mechanism  An incentive mechanism is generally used to incentivize individuals or organizations to reach targets or carry out certain actions. This can take the form of rewards, financial incentives or other benefits., a consensus mechanism motivates the network participants in a blockchain (as if by an invisible hand and with no central authority) to add solely valid transactions to the blockchain. This is because these participants would benefit less, or even be penalized, for trying to store invalid transaction data in the blockchain. Consequently, consensus mechanisms are in fact security mechanisms, which makes them an essential component of any blockchain.

Proof of work (PoW) and proof of stake (PoS) explained

There are now many different consensus mechanisms. The most popular include “proof of work” (PoW) and “proof of stake” (PoS). The Bitcoin blockchain, for instance, is based on the PoW consensus mechanism. Ethereum, the second biggest blockchain by market capitalization, has been based on the PoS consensus mechanism since September 2022. Prior to that, Ethereum was also based on proof of work.

In percentages, the PoW consensus mechanism dominates the blockchain world. As at the end of October 2023, 55.77 percent of all blockchain market capitalization is based on proof of work. But this is mainly because Bitcoin is still by far the biggest blockchain by market capitalization. In addition to Bitcoin, other well-known blockchains, such as Dogecoin, Litecoin, Bitcoin Cash, Monero and Ethereum Classic, are also based on this consensus mechanism.

Proof of stake, meanwhile, accounts for 22.4 percent of total market capitalization (as at the end of October 2023) and is primarily found in smart contract blockchains. Besides Ethereum, it is mainly the more recent generation of blockchains that are based on this security mechanism, including BNB Chain, Cardano, Polkadot and Avalanche.

Proof of work: energy secures the blockchain

With a PoW blockchain, it’s the miners who add blocks to the blockchain. However, they cannot do this whenever they like. To be able to add a block to the blockchain as a miner, a proof of work must be produced. Only miners who produce this are permitted to add the next block to the blockchain.

But what does this proof of work consist of, and how do miners produce it? The proof of work involves finding a mathematical number, also known as a “nonce”. To find this number, miners must use computational power. This is generated with processors, which in turn require electricity to run continuously. The more computational power that is used, the greater the chance miners have of finding the number and subsequently being able to add the new block to the PoW blockchain.

A fitting analogy is looking for a needle in a haystack. The person who finds the needle is able to add the next block, and they receive the block reward. As the proof of work is part of a mathematical-cryptographic process, its validity can be scrutinized with ease by other miners.

Proof of stake: capital secures the blockchain

While proof of work involves miners, a PoS system involves validators. These validators must hold a certain proportion of the blockchain’s own cryptocurrency and entrust it to the corresponding blockchain protocol. The technical term for this is “staking”, and the term “staker” is occasionally used as a synonym for validator. Staked cryptocurrencies are locked by the blockchain protocol and released only after a certain period of time.

In the case of proof of stake, it is the validators’ responsibility to add transactions to the blocks and, in doing so, to maintain the PoS blockchain. A deterministic algorithm decides which validators are allowed to add a new block to the blockchain, and this algorithm takes numerous factors into account. For instance, the number of staked coins is relevant to how likely it is that a validator will be selected. As a rule, the higher their own stake is, the likelier someone is to be the validator of the next block.

However, the amount staked alone is not decisive. If this were the case, it would result in the blockchain being centralized. For this reason, there are various other factors that are also key to determining the validator, including how long a staker has held their staked coins and the staker’s activity and performance.

The similarities and differences between the two consensus mechanisms

Pros and cons of the two consensus mechanisms

As long as the two consensus mechanisms have existed, there has been an enduring debate on which one is superior, and aspects such as security, energy efficiency, scalability, robustness and centralization tendencies are often brought up in comparisons.

However, as is so often the case, it’s not a clear-cut matter. Proof of work and proof of stake both have their conflicting goals, meaning they require different trade-offs. Taking this basic assumption, though, we can categorize the main pros and cons of the two blockchain systems as follows:

Energy vs security

With proof of work, it’s the energy used by miners that secures the blockchain. Proof of stake requires far less energy by comparison, as there is no CPU-intensive mining involved. This fact makes PoS more environmentally friendly and sustainable in the minds of many blockchain enthusiasts.

While this view may sound persuasive enough at first glance, we can still certainly subject it to some criticism. Proof of stake still has its opportunity costs. Instead of computational power, which uses electricity, capital is tied up in the form of the blockchain’s own coin, which cannot be used for alternative purposes. However, this issue is counteracted with liquid staking opportunities, which increases the complexity of the system as a whole. Whilst the use (or, as some would say, waste) of electricity and hardware is more apparent in the case of PoW, this is less evident with PoS when it comes to capital and financial liquidity.

Scalability vs centrality

Proof of stake is classed as a more scalable consensus mechanism than proof of work, which is why the former in particular is also used for smart contract platforms, which have to process a high quantity of transactions. At the same time, PoS blockchains tend to offer developers more leeway in designing smart contracts. This is down to the fact that they come with fewer limitations as far as script language and other technical aspects are concerned.

This greater scalability does, however, come with a greater tendency towards centralization. While proof of work – as the example of Bitcoin demonstrates – seems to become more decentralized over time, a PoS system such as Ethereum tends towards centralization. As the biggest group of validators, Lido currently accounts for over 31 percent of all validators active in Ethereum. The top five staking providers actually control over 50 percent of the Ethereum network.

You commonly hear the argument that Bitcoin is also showing signs of centralization, namely in the Bitcoin mining pools. Indeed, the top five mining pools hold over 83 percent of the Bitcoin hash rate. However, on this point, it should be noted that mining pools are the same as the miners themselves. Mining pools are simply node service providers that do not look after any mining hardware. It’s really the miners who do this, which means that the control of mining pools is relatively small.