Solving the Cryptocurrency Puzzle

Cryptocurrency gives people a glimpse of what our financial system could look like in the next five to ten years. From its infancy, we’ve already seen the potential of cryptocurrencies like Bitcoin and Ethereum to revolutionize traditional banking through a system of payment which doesn’t require intermediaries.

This method is proving itself as a fast, reliable, and cost-effective means of communicating value, touted by enthusiasts as the Internet of money, far better than our centuries-old banking system with its painfully slow and costly transactions. However, in recent years, we’re starting to see some of its growing pains as it goes through the slow process of mass adoption.

Developers are now looking into these problems with a renewed sense of urgency as cryptocurrencies gear towards mainstream integration. It is expected for the next couple of years to be the most turbulent in all of cryptocurrency history, and one which will decide the fate of our status quo.

 

In Search of the Missing Piece

Blockchain protocols lend to the blockchain’s immutability and varying degrees of decentralization. Like any software, they are far from being perfect. There are over a thousand cryptocurrencies in circulation today, and all of them will have to somehow deal with their own issues one way or the other.

Bitcoin has had a number of BIPs to solve this lingering problem of slow confirmations. By mid-2017, they managed to increase the block’s capacity by almost double without causing compatibility issues with old, existing wallets. With the adoption of Segwit, Bitcoin accomplished two things at once: fixed a software glitch (transaction malleability), and reduced confirmation times.

However, such measure won’t guarantee a long-term, let alone permanent solution, to Bitcoin’s transaction woes. At the time of writing, there are over **50,000 pending transactions in Bitcoin’s blockchain mempool, waiting to be confirmed, and they’re constantly piling up at a rate of 2-3 unconfirmed transactions per second. Developers have been working round the clock testing and finalizing Lightning Network for Bitcoin, the success of which will enable Bitcoin to break the sound barrier and bring this whole debate of scalability into a close.

(**That number went down to <2,000 unconfirmed transactions, probably due to increased Segwit adoption by wallet users and providers, or to some early adopters of the Lightning Network.)

Ethereum has had its own share of problems and fixes, most notably the Decentralized Autonomous Organization (DAO) attack of June 2016 and the hard fork that ensued to prevent further loss of funds. Smart contracts is one of Ethereum’s major selling point which enabled contracting parties to make an agreement that executes after satisfying certain conditions, or rolls back if it hasn’t.

Ethereum’s biggest hurdle is the ominous “difficulty bomb” built into the system which makes it nearly impossible to mine without incurring losses to miners after a certain point in time. Hence, the only solution is to migrate from a “proof of work” to a “proof of stake” method of confirming transactions. With the release of the Casper update for Ethereum, they hope to achieve exponential rate of confirmations and scalability in preparation for worldwide adoption.

 

The Proof of Work Concept

Proof of work had its roots in the early 90s to deter users from launching denial of service (DoS) attacks performed by spamming websites and establishments with superfluous requests. Interestingly, proof of work was also coined from the standpoint of giving value to a currency like the shell money used by inhabitants of the Solomon Islands.

Proof of work underpins major currencies such as Bitcoin, Etherium, Bitcoin Cash, and Litecoin in confirming transactions on a blockchain, which can only be achieved through mining. Proof of work helps create a system which is resistant to fraud and hacking since there are no viable means to circumvent the process except by brute-forcing through an inordinate number of trial-and-error.

In proof of work, only truth matters, in this case, the correct nonce and the corresponding hash which would allow transactions to be confirmed. In return, miners are rewarded for their efforts and new units of currencies are created and added into their accounts (hence the idea of mining).

Such method opens up the possibility of individuals with the most powerful mining hardware taking control, and in effect centralizing all the hash power to an elite few. Thus, a self-regulating mechanism was put in place to assure that only a specific number of confirmations can be done at a given time (difficulty increases/decreases with the network’s hashing capability).

Bitcoin also has several BIPs to increase network efficiency, such as the inclusion of mining fees. With this, they hope to alleviate congestion by putting a premium on higher transaction fees and eliminating the possibility of saboteurs spamming the network with high volumes of worthless micro-transactions.

As it turns out, some solutions can also have unforeseen consequences down the line, namely, difficulties with scaling. The first cryptocurrency, Bitcoin, was not really intended for everyday use but only as an alternative means of exchanging value outside the realm of government regulations. Scaling would not have been an issue back then. However, much has changed, and more countries and businesses are looking towards cryptocurrency as the way forward to their old and antiquated monetary system.

 

Proof of Stake and Its Potential Risks

Proof of stake adds another twist to the way transactions are confirmed. Similar to mining, participants validate and confirm transactions which are added on top of the blockchain. However, instead of using hash power, they would stake their currencies and lock them up for each round of staking. It also requires continuous uptime in order to be chosen by the algorithm, and, by being chosen, confirm transactions, and receive their rewards.

There are many nuances on how proof of stake are implemented in various cryptocurrencies based on how they try to mitigate the risks associated with staking, e.g. monopolozing, inflation rates, and network stability. Most prominent among cryptocurrencies which use proof of stake includes Peercoin, Blackcoin, Nextcoin, Bitcoin Plus, Cardano (premined) and soon to be Ethereum Casper update.

Staking is touted by several crypto-enthusiasts as the only road to scalability and worldwide adoption because it solves a lot of issues with associated with mining which uses proof of work such as power consumption and confirmation times. Although plausible with proof of stake being cost-effective and faster than proof of work, it could quickly turn into a can of worms if not implemented correctly.

Proof of stake tend to favour “stakers” (the equivalent of “miners” using proof of work) with huge quantities of currencies in reserve as they could handily beat small-time stakers with the increasing level of difficulty. Stakers can do the same thing as did every miner, creating a pool of stakers or the so-called master nodes to consolidate all their assets and have a fighting (or “winning”) chance of being randomly selected by the algorithm to confirm transactions.

Some proof of stake implementation prevents monopoly by capping the amount of currency that could be staked, “coin age,” and ticket waiting times. Putting a limit to staked currencies is intended to level the playing field for everybody and encourage more people to participate in staking. On the other hand, coin age and ticket waiting times regulate the frequency participants can stake, Peercoin, for instance, is set to a minimum of 30 days and a maximum of 90 days.

Inflation and network stability are some of the common issues with a proof of stake protocol. Developers are careful enough not to overdo one aspect over the other and seal off potential gaps and loopholes that can cause instability or discourage people from participating. Most proof of stake protocols and algorithms are still in the process of development and rigorous testing. The much anticipated Casper update for Ethereum could be released anytime this year, effectively moving to proof of stake through a hard fork.

 

Ripple and the Consensus Protocol

Consensus seems to be the antithesis of a decentralized method of confirming transactions which rely on proof of work or proof of stake. At its core, it is a trust-based method whereby transactions or any form of agreement between two parties are validated and confirmed by way of consensus. The result is almost instantaneous confirmations, averaging at a rate of 1500 transactions per second.

Ripple breaks the mould by being the first to implement the cryptocurrency version of the “hawala” system, allowing it to deliver lightning fast transactions outputs consistently at only fractions of a penny. However, there is an obvious downside with this kind of method. Despite having the trappings of decentralization as one of the cryptocurrencies listed in exchanges, it is, by all accounts, a centralized currency backed by tech giants and financial institutions.

Unlike mining and staking, there are no incentives as a “validator,” except that fact you earn more trust and contribute to the stability of the whole network. Validators are usually large entities like banks and commercial establishments which might benefit from it through cross-border transactions. However, since all the currencies that will ever exist are already pre-mined, the currency’s value and every asset tied to it are at the mercy of whoever holds the majority of it (hint: 55% is held in escrow by Ripple).

 

The Lightning Network and the New Bitcoin

The proposed Lightning Network solution for Bitcoin, Ethereum’s plan on moving to proof of stake, and Ripple’s meteoric rise towards the end of 2017 sends a strong signal to the cryptocurrency community and to the world that a major change in the current financial system is forthcoming.

Lightning Network, if successful, will usher the golden age of Bitcoin and cryptocurrencies in general. In so doing, we might also have a slightly different view about the new Bitcoin, particularly with its strong stance for decentralization. We might have to welcome the possibility of having off-chain payment channels and smart contracts to communicate with the blockchain instead of having every wallet users transmit countless numbers of micro-transactions to the blockchain every single time. The result would be a dramatic increase in transaction outputs, and the ability to scale with a fast-growing number of users.

Lightning Network could be the missing piece of the puzzle, the final solution to Bitcoin’s scalability issues, and the last hurdle towards worldwide adoption. But it is, by no means, the only way. If, for some reason, Lightning Network failed to materialize, it would not be the end of the road for Bitcoin. It would just be the beginning of a long journey towards perfection and worldwide adoption.

 

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