Cryptocurrency: Functions

Functions

WHAT IS A CONSENSUS ALGORITHM?

All cryptocurrencies function on the back of what is called a consensus algorithm. This is simply a set of rules dictating how a blockchain behaves and interacts with its users and will often be the defining factor when differentiating a cryptocurrency’s purpose, performance and worth.

The core purpose of this set of rules is to determine how a blockchain’s cryptocurrency transaction is validated.
Types of consensus algorithms generally fall into four categories - Proof of Work (PoW), Proof of Stake (PoS), Tokens, and Stablecoins.

Proof of Work (PoW) cryptocurrency is where it all began, and the type of currency still most commonly being used today.
PoW cryptocurrency, like Bitcoin, relies on the original concept of blockchain technology to process transactions.
The action of mining from nodes, verifying transactions and adding blocks to the chain is the work part of Proof of Work, while the proof is the public access to the ledger.

This system is popular because of its network design and resulting security capabilities – the larger the network, the more secure it becomes.

However, the fast-evolving nature of cryptocurrency has seen many innovations during its short time in use, including ways to avoid some issues with using PoW cryptocurrencies.
Every user on the network is connected through a node, and every node must work and complete a copy of every transaction for the blockchain to remain functionable.

Proof of WorkProof of WorkThe hash function not only acts to confirm the validation of a block before it is added to a blockchain, but also leaves a digital signature of the miner completing the work required to perform the task.

This entire PoW network relies on a huge amount of computer power to work. For Bitcoin’s PoW network, it needs the same amount of electricity required to power Switzerland to continuously function.

This makes the PoW process relatively insufficient compared to new innovations in cryptocurrency, potentially putting its dominant status in the market at risk.

WHAT IS THE DIFFERENCE BETWEEN POW AND POS?

Proof of Stake (PoS) cryptocurrency attempts to combat PoW’s overreliance on computer power and electricity by using a scaled down version of the original all-in blockchain network system. Instead of relying on every single node validating every transaction, PoS uses a model requiring only smaller groups of nodes to confirm the transfer of cryptocurrency ownership.

While its whole-network verification made PoW the most secure type of cryptocurrency during the technology’s infancy, PoS has found a way to maintain security without the reliance of an entire network of nodes having to contribute to every transaction.

Instead, select groups of nodes guarantee transactions by fronting their own cryptocurrency as a deposit. Before working on adding a block to the chain and validating a transaction, these nodes must offer a proof of stake, which they receive back with reward when the task is successfully completed.

Proof of StakeProof of StakeA scaled down version of Proof of Work relying on only smaller groups of nodes to confirm the transfer of cryptocurrency rather than an entire network.

If a node attempts to falsify a transaction or introduce incorrect data, they forfeit their stake.

This alternate version of cryptocurrency security and transaction is often seen as the future of blockchain-based systems, thanks to its significantly lower reliance on computer process speeds and electricity usage.

However, despite PoS innovation in security, the original design and reliance on the contribution of the entire system of nodes means PoW is technically a more secure system.

A PoS implementation of financial punishment for verification indiscretions means there is potential for a manipulation of the system to offer greater reward than penalty. It also risks node monopolies and the erosion of a cryptocurrency’s decentralised status.

As a single node or a group of node’s working in tandem increase their abilities to generate income from adding to the blockchain, so does their bidding power and capability of taking over large parts of the network.

Cryptocurrency: Functions

WHAT ARE TOKENS?

While PoW and PoS cryptocurrency differ in their use of blockchain technology, tokens TokensA type of cryptocurrency created on top of existing blockchain systems acting as another layer of tradable equity, like how chips represent cash in a casino. Different from cryptocurrency coins earmarked for tender. are different in their application, in that they are not intended for use as currency.

Tokens are created on top of existing blockchain systems and act as another layer of tradable equity, like how chips represent cash in a casino. Another analogy used when explaining tokens is how they work in the same way as stock or bonds in that they represent cryptocurrency and cannot be spent before they are converted.

They are also like stocks in their multi-purpose application.
Tokens can leverage blockchain technology to represent more than just cryptocurrency, but all sorts of value and physical assets. The benefit of this wide variety of uses makes tokens very flexible in offering an idea of value.

However, it may be difficult to understand a token’s worth before it is converted into cryptocurrency tender, and its worth is exclusively reliant on the performance of the blockchain with which it is connected.

This issue is magnified for tokens by the fluctuating value of regular PoW and PoS cryptocurrencies and the blockchains to which they are attached, but there are alternative types of cryptocurrencies designed to combat this issue.

This type of cryptocurrency is a stablecoin, which is enormously popular because its primary focus and design feature is to offer consistent value.

WHAT ARE STABLECOINS?

Stablecoin stablecoinA type of cryptocurrency specifically programmed to maintain a stable price value.s have a hybrid blueprint, offering the best benefits of tokens, PoW and PoS in a single package. They are similar to tokens in the way they are built on top of blockchains and represent value rather than hold value themselves. And they are similar to PoW and PoS in that they can be exchanged directly for traditional currency.

But it is stablecoins' more unique properties offering steady worth making them the most relied upon cryptocurrency for regular transactions. This is achieved usually by aligning their value with fiat currency, like the US dollar.

While this sounds good in theory to most regular users of cryptocurrency, there are drawbacks in practice too, mainly surrounding stablecoins’ reliance on third parties for functionality.

Stablecoins are managed by companies or single entities holding real cash reserves to guarantee their value.
This means there are higher risks of mismanagement or maladministration could see the value of a stablecoin suddenly disappearing.

Without large-scale management usually seen with government or corporate intervention, the value of stablecoins is at the mercy of a few.

FAQ

What types of cryptocurrencies are there?
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All cryptocurrencies function on the back of what is called a consensus algorithm. This is simply a set of rules dictating how a blockchain behaves and interacts with its users and will often be the defining factor when differentiating a cryptocurrency’s purpose, performance and worth. The core purpose of this set of rules is to determine how a blockchain’s cryptocurrency transaction is validated. Types of consensus algorithms generally fall into four categories - Proof of Work (PoW), Proof of Stake (PoS), Tokens, and Stablecoins.

What is Proof of Work?
arrow arrow

Proof of Work (PoW) cryptocurrency is where it all began, and the type of currency still most commonly being used today. PoW cryptocurrency, like Bitcoin, relies on the original concept of blockchain technology to process transactions.

What is Proof of Stake?
arrow arrow

Proof of Stake (PoS) cryptocurrency attempts to combat PoW’s overreliance on computer power and electricity by using a scaled down version of the original all-in blockchain network system. Instead of relying on every single node validating every transaction, PoS uses a model requiring only smaller groups of nodes to confirm the transfer of cryptocurrency ownership.

What are Tokens?
arrow arrow

While PoW and PoS cryptocurrency differ in their use of blockchain technology, tokens are different in their application, in that they are not intended for use as currency. Tokens are created on top of existing blockchain systems and act as another layer of tradable equity, like how chips represent cash in a casino.

What are Stablecoins?
arrow arrow

A stablecoin’s primary focus and design feature is to offer consistent value, while offering the best benefits of tokens, PoW and PoS in a single package. They are similar to tokens in the way they are built on top of blockchains and represent value rather than hold value themselves, and they are similar to PoW and PoS in that they can be exchanged directly for traditional currency.

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