Proof of Stake Vs Proof of Work — an Economic Policy Perspective to Digital Consensus.

The following is a short blog entry for the module ‘Rethinking Capitalism’ at University College London.

The rise of blockchain (interoperable data sharing systems) and cryptocurrencies (digital tokens used for running blockchains) have ushered in a new array of digital regulations that serve as guidelines within these systems. These guidelines, called consensus mechanisms, dictate how the network comes to a decision. Consensus mechanisms are not as open to interpretation as real-world economic theories, for they are hardcoded into each network’s protocols; nonetheless, they serve as the rules and regulations of a blockchain economy determining the crypto-economic equivalent of interest, inflation, and tax rates.

A consensus mechanism is a set of algorithms that serve as a network’s rules and regulations, they can be considered as the system’s policies. They operate through complex algorithms and system wide protocols that affect the nature of each network. Various consensus mechanisms have been designed for different blockchain economies, but they usually fall into 2 categories: Proof-of-Work (PoW) or Proof-of-Stake (PoS). Both PoW and PoS are derived from economic theories that reflect the intentions of the network. However, after years of growth in the industry, both popular policies have been heavily criticised, and their shortcomings can be also be seen in issues regarding modern day public economic policy.

Satoshi Nakamoto designed the bitcoin PoW “Nakamoto Competition” model which popularised the concept. PoW operates within the bitcoin blockchain by delegating the issuing of ‘coin’ to actors called miners. Miners run the blockchain by solving cryptographic functions, that are created with each transaction in the network, using hardware with enough computing power called hash rate. The greater the hash rate the more cryptographic functions a miner can solve and therefore the more coins he is awarded by the blockchain. It is this hash rate that reflects the overall competition of the network. According to Nakamoto competition, any member of the blockchain can become a miner and therefore compete for the mining rewards.

In this sense, PoW draws much of its economics from neoliberal policies. Any user with access to the blockchain can compete by operating as a miner which creates a completely unregulated free market. Similar to how PoW enables free-market competition, Thatcherism and Reaganomics redefined the market of the 1970s-1990s through deregulation and laissez-faire absolutism. This type of policy was key in solving real world issues such as stagflation, but its deregulation enabled corporation to grow unsupervised and develop oligopolistic economies, mass inequality and failed to account for market failures or irregular aggregate demand. Bitcoin is no exception. As soon as the market expanded, large mining pools developed, facilities with powerful processing hardware able to compute thousands of cryptographic equations a second, in regions with cheap electricity to lower marginal costs of production, and nowadays almost 90% of all BTC is mined in China.

PoW, like much of mainstream economic theories, is based on principles of perfect competition and market equilibria. Under perfect competition, PoW is designed to induce economic equilibria, where in the long-run marginal costs are equal to marginal revenue and a large enough competition-base will move the market towards price-cost equivalence. Nakamoto’s goal for bitcoin was to develop a stable payment system, therefore the economic policy was designed to achieve a stable price equal to the operational costs of mining bitcoin resembling classical economic perfect competition models. Furthermore, similar to how Reaganomics lowered taxes and improved accessibility to cheap goods, PoW’s unregulated competition showed its ability to lower payment fees as competition increased. Figure 1 shows how the increase in competition (Hash rate) stabilises the operating fees, enabling access to all users.

1 PoW’s Competition (Hash Rate) & Transaction Fees over Time

Proof-of-Stake, PoS, aims to solve several of the policy issues of PoW. Firstly, PoS relies on users having a stake on the network, that is an amount of currency they are willing to bond to their own account. If they misbehave, this stake is “slashed”- deleted from the system- and this punitive regulation acts as a quality assurance. Secondly, to avoid unregulated competition, PoS policies randomly select stakeholders to append to the blockchain as oppose to having large mining pools competing for rewards. Users with a larger stake will have a greater chance of being selected to verify transactions and earn rewards. PoS consensus draws much of its economics form New Keynesian policies, since it accounts for imperfect competition, and dynamic fees that change depending on network activity, resembling varying examples of fiscal policies.

However, critics are quick to point out the issues PoS consensus can have on the economy of a blockchain. Firstly, although competition cannot be centralised like in PoW, it can create larger inequalities between users. Since issuing coins depends on how large the user’s stake is, PoS benefits mostly the large stake users, neglecting the smaller stakers and only large stakers can afford to buy, transfer, or simply pay the increasing fees in the network; as a result, the inequality between small and large stakers grows, and inflation drives the asset-price and fees higher than small stakers can manage. Figure 2 shows the greater volatility and correlation between competition and network fees in Ethereum, a now PoS system. This is due partly to the increased governance of PoS networks, Ethereum and other PoS blockchains usually have some form of governance, unlike pure PoW networks, a governing body can alter the network’s transaction fees or other technicalities to avoid market failures. A more active governance resembles the Keynesian policies and differs significantly from PoW neoliberal roots.

2 PoS’s Competition (Hash Rate) & Transaction Fees over Time

While most current economists tend to consider the economy in terms of equilibria, economic phenomena are essentially dynamic and highly complex. Regarding a nascent cryptocurrency, this means that we cannot talk merely about some final stable state but rather an intricate ecosystem. To appropriately develop these new technologies, governments and developers alike must have in mind the economics of tokenised networks and the policies that run them. Given the similarities between consensus mechanisms and economic policies, learning about one will likely benefit the other. Embracing both algorithmic and real-world economic regulation can result in a better understanding of both the economy and the rapidly developing blockchain industry.

(998 Words)


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