- P2P can be implemented in a secure way between users using blockchain without the middleman.
- Transparency is a core of creating trusted space in an environment, where total distrust is normal.
- Accounting remains on the clients’ side.
So, while the classic blockchain model worked great during the infancy of cryptocurrencies, in time the burden of registering every transaction by every actor in the system became unbearable and counter profitable. Why?
As we have previously established, a true blockchain is based on decentralized storage of the decentralized ledger by every user in the system.
But imagine if our blockchain grows to 1 million accounts. It means that every transaction on the blockchain should create 1 million copies in one million accounts. And it should be done by every user, even those, who don’t make transactions. Try to imagine 5 thousand of such operations – that’s 5 billion records! And what if these operation logs are quite hefty? The whole process might slow down almost to a halt. And “stable” would certainly be one of the last words to describe such a system. Meanwhile, stability will always be among crucial traits for any financial instrument out there.
Stabilizing a decentralized system
As we’ve previously stated, the literal decentralization had to be offloaded. Keeping the records had to be delegated to a number of machines with a powerful computing force and a good data plan. These machines are what we now call Nodes.
A Node is a machine, running blockchain software and keeping the record of the whole blockchain while being in constant contact with other nodes in this blockchain, checking it out for potential fraud and double spending. The more nodes there are in the system, the more secure and stable this system is. For example, Bitcoin currently has over 14 thousand nodes, which ensure the stability and fairness of exchange. And as we will see further, these nodes made the usage of the blockchain way more expensive.
This system is fueled by Nodes’ profit and this is exactly the source of the network fees: you all have been paying for your transactions. Let’s break down how a simple transaction is being processed by the network to see where the money goes.
We have users A and B. User A wants to send user B 3 coins. First, the transaction is requested.
The transaction then gets broadcasted to the network of nodes.
Nodes compete to register a transaction and get a reward for it. One of the nodes gets the job done faster than the others.
The transaction is then validated and added to the ledger. Everybody’s record status gets updated.
This is a basic scenario. In practice, the size of block, distribution model and method of obtaining a reward may differ from blockchain to blockchain.
But the basic idea is that:
- Commission is part of the infrastructure
- Reward is issued for performing complex computational work according to certain rules
- Nodes compete for rewards
How to keep the Nodes fair and unbiased?
We wouldn’t want to just blindly delegate the responsibility for the whole blockchain to a bunch of potentially sketchy people just for a nice piece of RAM and a few of graphics cards. What if they change all the logs and create false records, saying that the assets were sent to themselves or double spent? And because they keep the blockchain records, we wouldn’t be able to do much about it. Remember, trust is the core of the blockchain stability. So a reliable model of their integration into the blockchain had to be made.
That’s where Consensus mechanisms come into play. It’s a brilliantly simple concept that takes care of a fair intercommunication between Nodes and users.
How does a consensus mechanism work?
There are a number of different approaches to a blockchain Consensus. But all of them are basically iterations of these two main concepts:
Remember that moment, when Nodes were competing with each other to record a transaction and add it to the ledger? Well, in order to do that in PoW blockchains, a new block has to be mined. And it is done by Nodes spending computing power to solve a mathematical problem. The block is mined by the Node, which manages to be the first among others in solving the problem. The problem being solved in this case acts as a proof of the computing power being spent for mining of that block. There’s a complex mathematical process involved in this, which we don’t really have to get into for our purpose. If you’re interested in all the tasty technical stuff, here’s some helpful material.
The first node to solve the problem gets a reward. That reward is what attracts nodes and miners in the first place and acts as their means of profit.
Participants also have a consensus on the blockchain status and those who have a different (false) status, are automatically ousted from the system. And this mechanism subjugates both actors and Nodes.
As one would imagine, this consensus mechanism is very energy demanding because the Nodes are actually competing in a sort of an arms race against one another to mine the most blocks, thus getting the most rewards.
The Proof-of-Stake (PoS) evolves a more low-cost, low-energy consuming alternative to the PoW algorithm. It involves the allocation of responsibility in maintaining the public ledger to a participant node in proportion to the number of virtual currency tokens held by it. However, this comes with the drawback that it incentivizes cryptocoin hoarding instead of spending.
Being a node is obviously very profitable (in terms of these blockchains’ coins), since you get a reward for verifying each transaction in the network. That’s basically how nodes are primarily motivated to participate in the network.
And the expenses for rewarding Nodes lie upon the users of blockchain. Each transaction must include a fee to reward a validator Node. The transaction, which doesn’t cover the Nodes’ fee, just won’t get picked up and handled. Just like a taxi driver won’t take your order if you offer him nothing for the ride.
This fee is also subject to volatility. If there are a lot of transaction requests to be handled, the ones with higher fees for validators are more likely to get picked up, validated and added to the ledger. Getting back to the taxi example, it’s like ordering a cab on a rainy day, when there are obviously more orders than on a sunny day. So if you want to get picked up by a cab, be ready to pay the driver a bit more to prioritize your order and don’t get left in the rain. And these “rainy days” happen quite often in the crypto world.
There is no authority or sponsor that can bulk buy Nodes’ validations. The system just isn’t designed for that. This situation means that every actor interested in validating their transaction is supposed to “pay for the ride”.
There’s also an incentivization Consensus in the blockchain, so that nodes can’t do whatever they please and try to manipulate the ledger, putting the system’s stability at risk. This consensus is a form of coded agreement between participants on how the Nodes prove that they’re interested in the system’s stability. To be eligible for nodes, interested parties also have to make an investment, proving their long-term interest in the stability of the system.
There are two primary forms of such incentivization for this, and they’re dependent on the type of Consensus.
This is a consensus where participants agree, that those who put in the computing work, creating new blocks, and whoever manages to do it faster, are rewarded with a cryptocurrency of the blockchain. Thus, the creator of new blocks proves his interest in the stability of the system. This is the model that we’ve used to illustrate nodes in our previous example .
This type of consensus usually means fiat investments. Particularly, investment into the hardware, that would allow faster mining.
These are the fastest nodes.
This is a consensus, where participants agree, that proving your interest in the stability of the system is based on you freezing and holding a share of the assets, giving up your opportunity to sell them. This works as proof, that the further expansion of the network is more important to the holder as momentary gain. And these holders would get a reward for each validated transaction. And any attempt to manipulate the ledger and scam the system results in nodes losing their investments.
PoW and PoS both have skin in the game – that’s the idea of running nodes. The main difference between this incentivization is that Nodes of PoW chains are assets in the real world, while PoS – an asset in crypto world.
Hardware, incentivized for PoW can actually be sold in case of the system failure or depreciation. Frozen assets of PoS Nodes, on the other hand, are frozen for good, so the failure of a PoS system presents a much bigger risk for Nodes, just like any malicious act from those Nodes.
Consensus keeps the nodes in agreement with each other and users and keeps the nodes interested not only in stability, but in further development of the network (so that their assets grow in value), and keep the whole network offloaded, and transactions – fast and easy.
In other words, the nodes have a lot to lose in case of a system failure and a lot to gain in case of its prosperity.
But there have to be a lot of these nodes for an effective decentralized operation. And those nodes require a lot of money in fees to stay interested, thus making the decentralization more and more expensive. In some cases, the usage of the system is getting too expensive for smaller transactions to stay profitable and make sense. In this case, the effectiveness and swiftness of the transactions (and their high fees) begin to threaten users’ interest in such a blockchain. And that’s not a good place to be.
Decentralization turned out to be really expensive. And by design there are no ways to delegate fees to authorities or bulk buy them. Paying for Nodes validating transactions will always remain on users’ side.
The fees are subject to volatility. Due to the number of blockchain actors, the fees are only getting higher as the demand for validation rises.