Cardano has proven incredible for many reasons, with one of the most salient being its resistance to centralized entities. This revolutionary form of decentralization remains, however, a double-edged sword, as the ability to be resistant to centralized actors can come at a pretty substantial cost. Cryptocurrencies are decentralized and operate independently of conventional financial institutions; this does not, though, negate one all-too-pressing reality—that all transactions must be able to be verified.

How Do Cryptocurrencies Validate Transactions?

There are a growing number of ways that transaction validation can be accomplished from a decentralized standpoint that far exceed the rather antiquated proof-of-work concept that has become associated with the godfather of all cryptocurrencies, Bitcoin.

There currently exist the following alternative consensus mechanisms in the cryptosphere: proof of burn; proof of capacity; proof-of-elapsed time; proof-of-history; and, of course, proof of stake. This list is by no means exhaustive but nonetheless highlights an important point: that there are many ways to skin the proverbial crypto validation cat.

How Does Cardano Validate Transactions?

Our main focus for this article is Cardano’s proof-of-stake (PoS) method, as it is one that many other Etheruem-derived ERC-20 cryptocurrencies use. Understanding just how the consensus algorithm works within the Cardano framework allows us to form a much more comprehensive understanding of not only its advantages but also the limitations and potential pitfalls of some of the other competing proof methods.

Cardano transactions are continuously and thoroughly verified through the use of this popular consensus method that has come to be colloquially referred to as proof of stake. The concept of a “stake” should be fairly easy to grasp for those who have ever played poker. In poker a stake is defined as: the amount of a player's buy-in, or the amount of money that they are willing to play with in a given session.

In keeping with this traditional definition of staking, cryptocurrency owners can thus stake their currencies. By staking their Cardano holdings, owners are able to earn interest while also enabling validators to review and add new blocks of transactions to the blockchain. If all of this seems a bit technical, there is a great book written by none other than the great Vitalik Buterin that explains the philosophy underpinning proof of stake.

Staking one's coins, among other functions, gives one the ability to review fresh transaction blocks. This is a one-for-one swap but on a scale that is unfathomable to even imagine, as Cardano’s blockchain validators are able to process more than 1,000 transactions per second. Yes, per second! Yet don’t get too excited about that number, though, because just for comparison’s sake, the credit card company Visa can process up to 24,000 transactions per second.

But what about the OG in the crypto game? The highly controversial proof-of-work consensus algorithm, the original validation process found in Bitcoin, has grown out of fashion mostly due to environmental concerns. And it has been largely replaced by the proof-of-stake approach used by next generation cryptocurrencies such as Cardano.

Proof of stake has experienced a rise in popularity due to its improved energy efficiency, as people have grown more and more worried about the effects that bitcoin mining is having on the environment.

It is no understatement to say that it remains exceedingly wise for Cardano, and to a much larger extent cryptocurrency investors, to become familiar with proof of stake. Avoiding some of the marketing gimmicks of nascent cryptoprojects in our due diligence process involves having a full grasp of what has become the growing default for transaction validation.

In the unlikely event that there remains any doubt as to the ubiquitousness of proof of stake, here are a few of the major cryptocurrencies that employ it: Ethereum (ETH); Cosmos (ATOM); Solana (SOL); Polkadot (DOT); Binance Smart Chain (BNB); Avalanche (AVAX); Polygon (MATIC); and Tezos (XTZ). A great read, by the way, to help better differentiate between all of these projects is Reichental’s Cryptocurrency QuickStart Guide!

What is the Process for Proof of Stake?

Okay, we get it: proof of stake is sort of a big deal in the cryptocurrency world. But what exactly is proof of stake, and how does it work? The short answer is that it’s actually pretty cool, in that owners of a cryptocurrency like Cardano can build their own validator nodes and stake their coins using the proof-of-stake method. A node can be understood as a computer linked to a cryptocurrency network that performs certain tasks such as producing, receiving, and moving data.

To be even more precise, a validator node is defined as a special type of full node that participates in “consensus,” i.e., agreement. By participating in consensus, validator nodes take on the responsibility of verifying, voting on, and maintaining a record of transactions. Staking is the process of putting up your coins as collateral so they can be used to verify transactions made by other users.

Okay, so why the collateral, though? Cardano, like many of its competing cryptocurrencies, uses collateral to guarantee that nodes are compensated for their work in case validation fails. The stacked coins serve as a monetary guarantee given by Cardano users to assure that the contract has been carefully designed and thoroughly tested. Once your coins are staked, you won't be able to swap them; however, you can un-stake them whenever you want.

When a block of transactions is ready to be processed, the cryptocurrency's proof-of-stake protocol will choose a validator node to review the block of transactions. The block's transactions are evaluated by the validator to see if they are accurate or not. If they are, the block will be uploaded to the blockchain and the validators will receive payment in cryptocurrency for their efforts.

But, if a validator suggests the addition of a block that contains false information, they will lose some of their promised staked holdings as a result. This is to discourage the validators from engaging in sloppy work. Think of it like a waiter that loses a portion of their tip because they forgot the breadsticks!

But let’s be even more precise in our explanation. Anybody who has Cardano is free to stake it, and to make it even spicier, anyone can create their own validator node! Have you ever dreamed of wearing a visor and counting money for a living while using super complex technology? Here’s your chance!

So if you are truly keen on developing your own validator node, what you need to do is pretty straightforward. When a block of transactions needs to be verified, Cardano's Ouroboros protocol selects a validator. The validator—which, if it's your lucky day, is you—receives Cardano as a payment for their work after verifying and submitting new data to the block.

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How Does the Algorithm Know Which Validator to Go With?

In the proof-of-stake protocol, a validator's mining power is determined by the number of coins they are staking—with a player's likelihood of getting chosen to add more blocks increasing as their coin bet increases. The larger the stake on the validator’s part, the more staked funds that it can be matched, and the larger the amount of data it will be able to take on.

The stake in effect serves as a measure of resource allocation and depth. Think of it sort of like capital requirements to engage in traditional finance businesses such as banking and lending. Hypothetically speaking, the larger a company, the less likely it is to be enticed to participate in some petty grift.

Here’s the thing, though: Cardano and other cryptocurrencies are not created equal, as every proof-of-stake protocol has a different approach to how validators are chosen. The selection process will normally involve randomization, but it may also be influenced by other factors, such as the duration of currency staking by existing validators.

The possibility of being chosen as a validator exists for everybody who stakes cryptocurrency, but the likelihood of this happening if you are simply staking a small amount remains about as likely as winning the Mega Millions jackpot. Or, to make the likelihood of being selected even clearer, keep in mind that your chances of being chosen as a validator are about 0.001% if your coins account for 0.001% of the total staked amount. Thus it should be fairly obvious, for even the most tech-challenged among us, that the number of coins you hold directly affects your odds of winning.

Due to these high coin requirements, smaller entities increase their odds of winning by working together—which is to say that they join betting pools. A betting pool is easy to grasp in that the validator node is installed by the owner of the stake pool, and other users collect, i.e., pool their funds, in order to increase their chances of winning new blocks. When the block is officially validated, a share of the rewards is then distributed to each pool member, and the owner of the validator that everyone else pooled around will often tack on a small fee.

Which is Better: Proof of Work or Proof of Stake?

The two types of consensus methods that cryptocurrencies most frequently use are proof of stake and proof of work. The consensus-building algorithm of choice for early cryptocurrencies like Bitcoin was proof of work. On the other hand, proof of stake was first introduced by the now nearly-forgotten Peercoin in 2012 and has since grown in popularity among alternative cryptocurrencies. It should be noted that Peercoin did not entirely rely on proof of work as Peercoin (alternately known as PPC) also used a proof-of-work system as well. Also, contrary to what you may have heard around the water cooler, it did not go by the acronym OPP. Drum roll, cymbals crash!

As you may already know by now, the main difference between proof of stake and proof of work is the amount of energy that each technique demands. Miners must compete to solve challenging mathematical riddles in order to complete their proof of work: to add a transaction block and be deemed eligible for rewards the problem must be solved. This is insanely wasteful and inefficient in that all of the mining machinery is simultaneously computing the same problems, all over the world, thus inherently wasting a lot of electrical energy.

Using proof of stake, however, transactions can be certified in a way that is much more ecologically friendly because validators are not required to solve difficult equations while individually racing one another, every single moment of every single day. That, to me anyway, sounds like some form of technological slavery which goes against the very philosophy of cryptocurrencies as a whole. For a refresher on what that philosophy and vision is, make sure to read Satoshi’s Vision!

Another significant advantage that becomes evident when we highlight the differences between proof of stake and proof of work: PoS is less susceptible to the ever growing threat of centralization. In the proof-of-work method, the mining power is concentrated in the hands of a few large mining pools, making it easier for them to manipulate the network. The proof-of-stake method, however, is much less prone to this behavior because the amount of cryptocurrency held by a user determines their ability to validate transactions, and this decentralizes the process. Yes, having a lot of coins could lead to centralization, but this is neutralized by instituting betting pools!

Proof of stake also addresses some of the scalability issues associated with proof of work. With proof of work, as more miners join the network, the difficulty of the mathematical puzzles increases, making it harder to validate transactions. This is what people commonly refer to as a hash rate. As in: the hash rate is increasing. However, with proof of stake, the number of validators is not limited, and the network can handle an ever-increasing number of transactions without sacrificing network decentralized security.

Despite the many advantages of proof of stake, though, there are also some potential drawbacks. One issue is the potential for a "nothing at stake" issue, where validators have no financial incentive to act in the best interest of the network. Another concern is the possibility of a "51% attack," where a group of validators control more than half of the network's stake, allowing them to manipulate transactions. However, it will be interesting to see how proof of stake further evolves to address these challenges and others in the time ahead.

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