This thread has been a long time coming. For those who are not aware, for the past 5 months I have been writing an education section for the new Peercoin website. This originally began as two pages that covered the security and economics of Peercoin, however as I got deeper into it I realized that we needed something more in-depth.

Peercoin has always lacked a proper guide to introduce beginners to the technology and what makes it so special. The original whitepaper from Sunny King for example is not very newbie friendly. It’s very technical and leaves out most of the important arguments and insights about the technology.

This document I’ve written here is designed to be more friendly to beginners and fills in many of the gaps that are not covered by the original whitepaper. My hope is that it can act as the ultimate beginner guide for understanding Peercoin.

Much time was spent in trying to figure out how to order the information. I wanted to create something that was self-contained in which the reader did not need much prior knowledge in order to understand. For example I could not just begin by explaining proof-of-stake. I wanted the reader to understand everything, so I started at the very beginning.

First I explained why we are moving away from centralized entities. Then I explained distributed public ledgers, what the blockchain is and how it benefits society. Then I moved on to consensus protocols and first explained how Bitcoin’s security model works. Then I explained the many faults of proof-of-work. Finally I wrote about Peercoin and the benefits of proof-of-stake as well as its economic model and philosophy on scalability.

So it’s a pretty complete piece I believe. One thing I did not write about though is nothing at stake. If we want to include something about that then I will need more help. Many months were spent researching to write this and I felt I had already spent too much time on it. Delaying it yet again to further expand it did not feel like the right thing to do when we still need our website redesign to be finished. Now that this text is finished I will spend more time on the redesign so we can make more progress on it.

What I need from the community is for all of you to review this text. It’s very long and it’s possible I may have misunderstood something or made a mistake somewhere. I need help verifying whether all the information sounds correct. During this review process, please point out any errors you can find in this thread. If there is something missing that you think should have been included, please let us know below. Also if you think something I wrote could have been phrased better and you think you can help improve the text, don’t hesitate to let us know.

What we need right now are lots of eyes on it and people that can provide constructive feedback. My current plan is to place this text on the new website in its own section and it will be there for people who want to learn more. It is not the only learning material though as I understand I can’t expect people to read 47 pages in order to understand Peercoin. We will have much lighter reading for example on the home page along with graphic visualizations, however this text will also be available for those who wish to delve deeper.

I’d like to thank @peerchemist for putting up with and answering many of my constant questions during my research period. I know he anticipates the new website as well and was eager for me to finish this project up. Now I can move on to the next step in the process. I also want to thank everyone who reads this in the near future and provides feedback.

Table of Contents

1. Introduction

2. What is a Blockchain?

Centralized Private Ledgers

Distributed Public Ledgers

The Blockchain

Distributed Consensus Protocol

3. Benefits & Use Cases

Blockchain as Money: Cryptocurrency

4. Blockchain Security

Collusion

Consensus on a Single Shared Truth

Incentivizing Security by Validators

5. Bitcoin & Proof-of-Work Consensus

Mining Blocks by Solving Problems

Hashing Algorithms

Searching for a Valid Hash

Block Rewards

The Cost of Lying

Blockchain History Protection

6. Centralization of Bitcoin

Mining is a Profit Driven Competition

Mining Pools

Difficulty Adjustments

Domination by Large Mining Pools

Majority Attacks

Unsustainable Energy Consumption

Geographical Centralization of Miners

Diverging Interests of Miners & Users

7. Bitcoin’s Lack of Sustainability

Voluntary User Transaction Fees

Block Reward Halving

The Tragedy of the Commons

Short-Term Behavior Sabotages Long-Term Security

Security is Dependent on Price

8. Bitcoin’s Lack of Scalability

The Block Size Limit

Block Size Limit Increases & Centralization of Full Nodes

2017 Bitcoin Chain Split

Transaction Fee Market

Block Size Limit Solves Block Reward Halvings

Block Size Limit Impacts Network Usability

Bitcoin as a Settlement Network

Secondary Layers & Off-Chain Transactions

The Lightning Network & Payment Channels

Blockchain as a Base Layer

Putting it all Together

Fee Competition Between Miners & Secondary Layers

Conclusion on Bitcoin & Proof-of-Work

9. Peercoin & Proof-of-Stake Consensus

Time as an Alternative Scarce Resource

Time Based Rules & Restrictions

Majority Attacks are Cost Prohibitive

Attackers are Financially Tied to the Network

10. First Efficient & Sustainable Blockchain

Qualities of Proof-of-Stake Consensus

Higher Resistance to Censorship

Reduced Incentive for Minters to Centralize

Minting Pools

Cold Minting

11. Economics of Peercoin

An Unlimited, but Ultimately Scarce Supply

The 1% Standard

Pure Proof-of-Stake Distribution Problems

Hybrid Blockchain: PoS Security & PoW Distribution

Dynamic Proof-of-Work Block Reward

Inheriting the Mining Industry

Deflation Through Transaction Fee Burning

Benefits of a Fixed Transaction Fee

A True Digital Replacement for Gold

12. Scalability of Peercoin

The Backbone of Crypto

The Original Base Layer Settlement Network

Compatibility of Minters & Second Layers

Dynamic Block Sizes

13. A Stronger Foundation to Build Upon

1. Introduction

Peercoin was launched in 2012, making it one of the first blockchains to be released. It introduced a number of new innovations which substantially improved on the design of other blockchain protocols that existed at the time, principally Bitcoin’s proof-of-work. Peercoin’s alternative to proof-of-work, proof-of-stake, remains unrivaled to this day as a blockchain consensus protocol and one which is achieving more mainstream adoption with each passing year.

For the newcomer, understanding why Peercoin’s blockchain technology is superior first requires some understanding about blockchains in general, as well as understanding Peercoin’s primary competitor, Bitcoin; therefore we will start by learning what blockchains are, and what they offer. Once we understand this, we’ll cover the main problems behind the world’s first blockchain, Bitcoin, and how Peercoin has fixed these flaws.

You will discover that Sunny King, Peercoin’s original creator, had incredible foresight into the future of proof-of-work networks, and how Peercoin has been designed as a drop-in replacement in preparation for their inevitable decline.

2. What is a Blockchain?

Since the initial launch of Bitcoin in 2009, blockchain technology has proliferated throughout the world in many different forms. This new and exciting technology has the potential to impact society in innumerable ways. In this section we will explain what a blockchain really is, how it functions as well as its core purpose.

Centralized Private Ledgers

At its core, the Peercoin blockchain is a distributed public ledger. A ledger is traditionally a document such as a spreadsheet in which accounts are kept of economic transactions, including credits, debits, and balances. They are generally used to keep track of an individual’s or organization’s financial standing or other recordable data such as assets, liabilities, income, expenses and capital.

Before the invention of the blockchain, it was necessary for individuals to manage their financial accounts by placing their trust in a centrally managed third party organization which maintained its own private ledger. Example services include banks, credit card issuers, money transfer services and other financial institutions.

A high degree of trust is placed by customers in these centralized services and the people running them, all of whom are human and fallible. The ledgers of customer data are kept private and not routinely shared with the public for independent verification. In this outdated model, the customer is forced into a situation where they need to fully trust that the organizations handling their financial accounts are being truthful and accurate.

This lack of transparency is a central point of failure because it forces the customer to trust that the organization is acting in their interest and not against them. The need to trust without the ability to verify can invite errors, unaccountability and even outright fraud and corruption within an organization, which can impact customers in a damaging way.

Distributed Public Ledgers

Blockchain technology however completely removes the need for the user to trust a centralized organization in this way. Instead, the blockchain introduces the concept of a shared or distributed public ledger where a copy of the ledger is held by a large group of people all around the world who work together to validate transactions that are initiated by users of the blockchain network. The individuals who carry out this important work are known as validators.

Each validator hosts a full copy of the public ledger and operates a node, a program that validates incoming transactions and relays them to other nodes held by other validators. Together, these validators form a global network of nodes that secure the blockchain by protecting against fraud. Transactions initiated by users of the blockchain are broadcast across this network of nodes and they are either validated and accepted, or detected as invalid and rejected (as in the case where a malicious user attempts the same transaction twice in what is called a double spend attack).

Thus, rather than trust being concentrated in a central entity to manage its own private ledger without transparency or oversight, the blockchain distributes trust publicly and globally to a wide number of validators who work to prevent errors, alterations and acts of fraud. This open and transparent sharing of the public ledger allows each security validator the ability to independently verify the ledger’s integrity. In this way the public ledger acts as a digitally shared truth about the state of the network.

The Blockchain

The blockchain itself can be accurately described as a continuously growing list of individual transaction records called blocks. As transactions are initiated by users of the network they are broadcast out to the network of validation nodes. One by one these transactions are validated, grouped together and recorded into a block which is then attached to the end of the blockchain as the next link in the chain. Therefore every block is linked, forming one long cryptographically secured chain of blocks. When combined together these individual blocks of data form the entirety of the public ledger, which consists of all the transactions that have ever taken place on the network.

In Bitcoin and Peercoin, a new block is added to the chain about every ten minutes, which contains all the transactions made by users in that period. Account balances on the public ledger are consistently and automatically updated with each new added block to reflect changes from these transactions.

Distributed Consensus Protocol

Unlike a centrally managed entity that depends on user trust of authority figures who are capable of errors or intentional acts of fraud, the blockchain is designed with no such central point of failure. Instead user trust is placed in a blockchain’s distributed consensus protocol, which is an automated process responsible for achieving majority agreement among the network’s many validators on whether the public ledger can be considered valid or not. If the majority of validators working to secure the network can verify and agree that the public ledger is accurate and has not been tampered with, then it can be trusted as legitimate and held as absolute truth by all participants of the network.

A distributed consensus protocol is a coded set of rules that a blockchain runs on. This protocol and its underlying rules are entirely responsible for how a blockchain functions as well as its process for validating transactions and blocks. The protocol is also what gives the blockchain its many beneficial qualities, which are summarized below.

Automated: Since a blockchain protocol runs on code, security providers do not have to manually validate transactions and blocks, which means the consensus and verification process of the public ledger completely automated. From the standpoint of the end user, a submitted transaction is automatically processed by the network. From the standpoint of the validator, transactions submitted by users of the network are automatically verified and accepted or rejected by the node software they are running.

Trustless: For the first time in history, the blockchain can provide a network that is transparent, verifiable and one that can be trusted by all parties as it is impartial by its very nature. This unbiased or neutral quality of the blockchain is made possible by the public nature of the ledger and the ability of a large and globally decentralized group of security validators to verify its accuracy. This prevents the falsification of transactions and leads to a state of trustlessness in which all participants of the network can be assured that their data is guaranteed to be accurate. This state of trustlessness is the core value proposition of the blockchain. In this state the users of the network no longer need to trust anyone because security is automatically handled for them by the blockchain’s consensus protocol. Users only have need to trust that this protocol continues functioning as it was designed to.

Censorship Resistant: Censorship resistance is another quality of the blockchain. Banks and payment processors are centralized entities that have the power to interfere with transactions of their users and freeze funds, especially if forced to do so by governments. The blockchain introduces a level playing field where no one has power over anyone else and censorship or freezing of transactions is not possible.

Immutable: The blockchain is immutable, meaning that recorded data is permanent and cannot be tampered with. Data is therefore locked into the blockchain forever, making it impossible for attackers, governments and other external threats to alter or falsify that transaction data.

3. Benefits & Use Cases

Ultimately, these qualities combine to create a self auditing public record which can be used as a tool by people and organizations all over the world to conduct their day to day business. Use cases for the blockchain are plentiful, and new ideas are popping up every day. At a basic level blockchains features trustless mechanisms for money and data transfer, traceability and the chronological ordering of data. Digital identities can be created to represent data on the chain and provide proof of exactly when a piece of data was created, its history as well as the ability to prove ownership of data.

Data Verification: Immutability of the blockchain allows for the creation of robust audit trails of the data hosted on the chain. Searchability is improved as the blockchain can act as a common database for relevant records or even carry pointers to externally hosted data. Many industries still rely on physical documents to verify data, which is a manual process that is very time consuming and prone to loss of information and errors. Using blockchain technology can speed the digital evolution of industries that are still heavily reliant on outdated manual verification practices, and can improve the efficiency and integrity of virtually any process involving data validation.

Smart Contracts: Other use cases include smart contracts, which are self-executing applications with the terms and conditions of an agreement written directly into code. The rules and penalties coded into a smart contract do not require the services of a middleman as obligations self-execute automatically. Smart contracts are great for setting up automated agreements for exchanging different forms of value without conflict or interference from third parties.

Tokens: Token protocols make it possible to create assets or tokens that are hosted on the blockchain. Tokens can represent anything from equity in a company, to ownership of property, tickets for an event, or even coupons at a grocery store. Tokens are also great for business ventures seeking investors through crowdfunding or initial coin offerings.

Distributed Autonomous Corporations: Token protocols also make it possible for distributed autonomous corporations to be created, which are organizations or companies that use the blockchain for administration and governance. A distributed autonomous corporation can organize itself in a number of ways, including allowing token holders’ decision making power over the business through voting rights, and the ability to receive company profits through dividend distributions.

Blockchain as Money: Cryptocurrency

It goes without saying that blockchains have the potential to become competitors to traditional state sponsored paper fiat money in the form of cryptocurrencies. The first blockchain, Bitcoin, for example was originally invented by Satoshi Nakamoto as a replacement for fiat money, a peer-to-peer electronic cash system. It is believed by many that cryptocurrency can, in time, challenge existing financial institutions like central banks, which are responsible for managing monetary policy in various countries.

Where a central bank manages the supply of money in a centralized fashion with decisions being made by a core group of bankers, blockchains instead have strict coded rules about how new supply is introduced into the economy, how much and over how long a period of time. This makes distribution of new supply in cryptocurrencies more controlled and predictable and not subject to the changing opinions of central bankers.

Each blockchain can have its own separate rules regarding inflation of the supply and those rules can only be changed if a majority of network validators around the world agree to upgrade to the new rules, which prevents sudden changes from happening and helps maintain trust and stability in the system. In addition to controlled and predictable inflation, the blockchain also has a number of other benefits when being used as money:

Irreversible: Transactions are irreversible, which prevents chargeback fraud as seen with credit cards. Transactions also cannot be denied by the network itself.

Transparency: All transactions are transparent and easily viewable on the internet using tools like block explorers. This allows verification of data.

Pseudonymity: As long as a user’s personal identity is not linked to the address they transact with, transactions will remain pseudonymous.

International Payments: Cross-border trade is faster because payments avoid the delays associated with traditional methods.

Identity Protection: Merchants with poor security measures are at risk of losing credit card information to hackers, but with blockchains vital payment information no longer needs to be stored by merchants.

Convenience: There is no need to carry around a bulky wallet. With cryptocurrency your money can easily be transacted with by downloading various wallet apps on your phone.

Ease of Access: For those in developing countries who may not have access to traditional banking systems, cryptocurrencies can provide greater access to the rest of the world economy because all that is needed is a phone and an internet connection.

No Counterparty Risk: There are no third parties such as banks to rely on in order to transact with your money. Due to the direct person-to-person nature of blockchains, you can cut through any middlemen and send your payments directly where they need to go.

Independent Control: The automatic nature of transactions from one user to another offers independence from banks and an increased level of control over funds, essentially allowing you to become your own bank.

4. Blockchain Security

Although blockchain technology has the potential to transform finance as we know it, it’s important to realize that not all blockchains are the same. When choosing a blockchain to operate on, the most important factor to consider is the chain’s underlying security. If the blockchain is not secure, then it’s like building on top of quicksand. At some point it may be compromised, which could result in the total loss of all funds. It’s not just a question about whether a blockchain is secure right now, but whether it will continue to be secure in the future.

Collusion

A blockchain can only be considered trustless if there are a sufficient number of security validators and they are widely distributed around the world. Blockchain security stems from the fact that there are many validators and power is decentralized among them. This prevents collusion among validators as a great majority are likely to continue working in the interest of the network and its users. The few who attempt to collude and defraud will have no impact because they will be highly outnumbered by the many who play by the rules.

If a blockchain’s security protocol contained a design flaw that caused the number of validators to shrink over time then that would result in a highly centralized blockchain, which would completely defeat the purpose behind the technology as it could no longer be considered trustless. The fewer validators there are securing a blockchain, the more centralized it becomes and the more trust creeps back into the system making it just like the centralized organizations that we tried leaving behind.

As validators dwindle in number, the few that remain end up having a larger degree of influence and control over the network, which means there is a much higher chance they could collude and perform a double spend attack against the network. If a single entity somehow managed to gain majority control over the blockchain, then users of that blockchain would be at the mercy of that entity and would need to trust and hope that it would continue working in their interest instead of sabotaging the network for personal gain. The ideal blockchain is if validators continue to remain thoroughly decentralized so users of the network never have to trust anyone.

Consensus on a Single Shared Truth

A blockchain network’s ability to preserve its level of decentralization over time is highly dependent on how its distributed consensus protocol is designed. There are many types of distributed consensus protocols, but the two most well known are called proof-of-work and proof-of-stake.

These two consensus protocols operate in very different ways, but their overall goal is the same; to bring validators to consensus so they can agree on a single shared version of the truth regarding the state of the blockchain and its ledger, while at the same time preventing malicious or hostile actors from exploiting and derailing the system.

It is possible for certain validation nodes across the network to hold slightly different versions of the public ledger. This can happen if, for example, nodes are unreliable or slow because of issues with network latency, or because they are acting maliciously and run by people trying to fool the system by passing off their tampered version of the ledger as the real one.

Regardless of the reason for any disparity, it is the purpose of the consensus protocol to strive to keep all validation nodes synchronized so that a single version of the blockchain can be decided on, used and followed by all the participants of the network.

Incentivizing Validator Security

A consensus protocol achieves all this by incentivizing validators with monetary rewards in order to motivate them to perform validation and transaction processing work for the blockchain and its users. There are different types of validators however and not all of them receive this compensation for their work.

A full node is a validation node that has a full copy of the blockchain downloaded. There are three types of full nodes. The first type is run by individual volunteers or hobbyists who just want to help support the network, and so perform verification of transactions and blocks for free.

The second type are full nodes that are run by large entities such as merchants, exchanges and payment processors. These nodes are voluntarily operated, but the ability to monitor new transactions can give these entities benefits that can be passed on to their customers.

The third type of validator is only responsible for the task of building and adding new blocks of transactions onto the chain. These block producing nodes are different however and receive automated payments for their service from the network itself. In this way the blockchain literally pays for its own security maintenance and upkeep. Whether this validator is required to hold a full copy of the ledger differs with each blockchain. Block producers in Bitcoin are not required to hold a full copy of the ledger, whereas it is a requirement in Peercoin.

Validator roles can be thought of in this way. Simple validators who voluntarily run full nodes work to perform validation of transactions and blocks. Block producers however make it possible for the network to settle on a common truth every 10 minutes. If there was no consensus protocol to help decide who can produce the next block, anyone would be able to produce and submit a new block to the rest of the network. Validators would try verifying the transactions and blocks that were submitted to them, however each validator would end up checking a different block which would make it impossible to determine which block gets added to the chain. The consensus protocol ensures it is possible for these validation nodes to settle on a common state. Once this state is decided, it is broadcast to the rest of the network so that all validators work to verify the same block of transactions. It is a way of putting all validators in the network on the same page.

The way in which a blockchain’s consensus protocol is designed to incentivize validators to produce blocks is precisely what causes them to either retain or lose their level of decentralization over time. This is exactly what we need to learn in order to develop an understanding of which blockchain protocols are designed for long-term security and which are not.

5. Bitcoin & Proof-of-Work Consensus

In order to create Bitcoin, inventor Satoshi Nakamoto had to solve a number of problems: how to get a distributed group of validators to agree on the true version of the ledger; how to incentivize and motivate validators to process transactions and provide security for the blockchain network; how to prevent hostile entities from altering transaction records by tampering with the ledger’s history of events; and how to space out the production of new blocks so the time between each one is consistent and predictable.

Satoshi’s brilliance was in combining multiple fields of study in order to solve these problems, including incentive engineering, cryptography, game theory and computer science. This combination led to a solution for Bitcoin known as proof-of-work, also referred to as Nakamoto consensus.

Mining Blocks by Solving Problems

The specific validators who are responsible for producing new blocks in Bitcoin are called miners. The block production process itself is called mining. In order for a miner to add their newly created block as the next link in the blockchain, they are first required to solve a difficult math problem. The problem itself involves making lots of random guesses in order to find a solution that matches.

There is more than one possible guess that will work as an answer for each problem. Each time a miner makes a new guess, that guess is first combined with some other relevant data and then it is run through a hashing algorithm, a program that checks and verifies whether it is the correct answer. The first miner that solves the problem gets to add their block onto the chain.

Hashing Algorithms

The hashing algorithm is very important to the mining process, and not just for verifying whether the problem has been solved. When a hashing algorithm is fed data as input, the algorithm converts that data into an output in the form of a small string of numbers and letters. This output data is called a hash. A hashing algorithm only works in one direction, which means the hash that is produced from the input data will always result in the same string of numbers and letters as the output.

You could take an entire book as input data and run it through a hash algorithm and it will always produce the same resulting hash no matter how many times you do it. But if you were to change just a single character in the book and run it through the algorithm again, the resulting string of numbers and letters would be completely different. This makes it possible to verify whether something in the book or input data has been tampered with, even if it is something as slight as changing a single character.

If the resulting hash always contains the same string of numbers and letters each time it is run through the algorithm, then you can be sure that the input data was not tampered with. Every block in the blockchain contains its own hash, which acts as a guarantee that the contents of each block is true and unaltered.

Searching for a Valid Hash

In order to find an answer to problems, miners need to combine three pieces of data: the hash from the previous block, the transactions from the block they are currently building; and a random guess. They run this combined input data through the algorithm to produce a hash, which is then checked to see if it works as an answer to the original problem.

If the hash does not match, then it is considered an invalid hash, and miners will repeat this process over and over by changing their guess and hashing all three pieces of data until they find a valid hash. Only when a miner finds a valid hash can they be sure that the problem has been solved.

Once a miner succeeds in finding a valid hash, they broadcast their new block along with their correct guess to the rest of the validators on the network, who verify whether it is correct by also running it through the algorithm. This makes it possible for other validators to quickly establish whether the miner did the necessary work to solve the problem. Once validated, the block can then be accepted as the next block in the chain. If however validators are unable to produce a valid hash, the new block will be rejected. In the case of rejection, validators simply wait until another miner submits a new block that can be accurately verified.

This process is not done by miners manually, but automatically, using computer processing power. Modern computers are able to try thousands of combinations of hashes per second, so miners are capable of making many guesses very quickly.

Block Rewards

The process of mining blocks is expensive because of the use of electricity to power the computers that do the hashing. To make up for this cost, every time a miner solves a problem, that miner receives a block reward in the form of new bitcoin. These coins are automatically generated by the network with every new block that is produced. This is how new bitcoin is introduced into the supply and distributed over time.

Validators in Bitcoin are called miners because they are always digging for new coins by fulfilling the requirements of producing new blocks. Miners then sell the new coins they earn on the market to cover their costs while keeping the profit for themselves or reinvesting it in better mining equipment, which allows them to increase the hashes per second they perform along with their chances of earning more block rewards.

The Cost of Lying

The purpose of requiring miners to solve problems is to make it difficult and costly for miners to lie. For example, if a miner tries to include an invalid transaction in a block, perhaps to spend the same bitcoin twice, the miner will have their block rejected by the network. A rejected block means the miner will forfeit their block reward and lose money on the electricity they used to mine that block. Bad behavior is punished, resulting in miners having a financial incentive to tell the truth and play by the rules.

This process also explains how blockchains are designed to be immutable and unchangeable. For example, if a miner tried submitting an alternate version of the blockchain where they altered previous transactions, validators would detect the change because the hash of the altered block would no longer be valid.

Because every single block in the chain is cryptographically linked through hashing, an alteration in any one block would also cause the hash for every block after it to become invalid. The only way to truly alter a block in the past without detection would be to mine the altered block over again and every single block that came after it until the end of the chain. You would literally need to spend the resources to prove that you did the work to find a new valid hash for every single block after the one you altered. Currently it would cost billions of dollars to mine Bitcoin’s blockchain from scratch in order to change something, which is financially infeasible even for the very wealthy.

Proof-of-work consensus therefore acts as a financial deterrent against altering the history of the blockchain by forcing a massive cost on those who try to attempt it. By rewarding miners, it incentivizes them to tell the truth and submit blocks with accurate transaction data while also punishing those who attempt to cheat the system with the risk of losing invested funds.

6. Centralization of Bitcoin

Years of operating in the wild have exposed weaknesses in Bitcoin’s proof-of-work protocol. Blockchains can only be considered trustless if power is distributed among many network validators; proof-of-work’s design, however, has centralized its validators (miners) over time. This centralizing effect is inherent in the economics governing the proof-of-work protocol and cannot be eliminated by any technical improvement or upgrade of the code.

Mining is a Profit Driven Competition

Why is this? By its nature, proof-of-work incentivizes competition between its validators who, as miners, compete with each other to mine blocks, add them to the chain and receive their block reward of new coins.

To stay ahead of the competition, miners reinvest their profit in better mining equipment that increases their hashes per second. This allows a miner to make more guesses per second, which gives them a higher chance of solving a block’s problem before other miners. Miners who can afford to purchase this specialized mining equipment will have an edge over others when it comes to earning block rewards.

In the beginning, Bitcoin miners were plentiful, distributed and used basic computers to mine blocks. As time went on, miners began using more powerful and expensive machines to increase their hashing power. Eventually miners graduated to ASICs, which are customized chips designed specifically for mining. At each phase, miners were either forced to upgrade to faster and more efficient equipment in order to keep up with the competition, or face becoming obsolete as their block rewards dried up.

Domination by Mining Pools

The constant upgrading and lack of profitability led to a situation where smaller miners with obsolete equipment could no longer compete with the hashing power of larger miners. In order to increase the lifespan of their equipment, these small miners began pooling their processing power together into mining pools. Instead of block rewards being distributed to individual miners, mining pools split rewards among participants, allowing miners with outdated equipment the chance to receive smaller but more consistent rewards so they could continue competing a little while longer. Even with pools though, eventually mining equipment became obsolete and miners were either forced to upgrade or drop out completely.

Due to lack of profitability and the inability to compete, what began as a distributed network with a large group of individual miners has slowly devolved into an increasingly centralized operation with a small number of larger mining pools. The operators of these mining pools have been able to increase their power and influence over the network because they are now the ones responsible for submitting the majority of new blocks. Individual participants of a pool can contribute their hashing power and collect their partial block reward, but only the owners of the pools themselves can build new blocks and submit them to be added onto the chain. As a result, the Bitcoin mining industry has come to be dominated by a handful of pool owners.

Majority Attacks

This is precisely the situation that blockchains were designed to move away from, centralized control by entities that need to be trusted. If one of these large mining pools were able to obtain enough control over the hashing power, or if a few of the larger pools got together and colluded, they could perform a number of actions against the network and its users.

For example, they would be able to control who gets their transactions included in new blocks, effectively having the ability to temporarily prevent the processing of transactions from certain individuals. Someone having their transactions censored by a misbehaving mining pool would need to wait until a different pool produced a block that included their transactions.

Even worse is a double spend attack against the network in which the mining pool attempts to spend the same coins twice. This attack could potentially destabilize the network and compromise the trust users have in the system itself. Naturally, users are only supposed to be able to spend the coins they own once. Double spends have already been successfully performed against other smaller proof-of-work blockchains besides Bitcoin, so it is a possibility this could occur again in the future if the centralization of miners worsens.

With that said, miners are financially dependent on the Bitcoin network through the dedicated mining hardware they own. The sole purpose of this hardware is to mine proof-of-work networks like Bitcoin. It is useless for any other computing task. Therefore directly attacking the network in this way may render all this hardware useless as trust in the network is lost. The potential loss of invested hardware acts as a financial deterrent against attempting double spends against Bitcoin. This deterrent however would do nothing to stop a government sponsored attack with the sole purpose of bringing down the network. If such a situation ever came about and a mining pool was committing the attack, the only thing that could be done to stop it is for individual miners to withdraw their hashing power from that misbehaving pool and move it to another.

Unsustainable Energy Consumption

Centralization of mining power is not the only major concern. The level of energy consumption by miners to keep the network securely operating is growing larger by the day. While it is difficult to accurately determine, current estimates put Bitcoin energy expenditure in the same league as the consumption of some medium sized countries in an entire year, and this is only expected to increase as time goes on. Such energy consumption just to secure a distributed network and prevent cheating is incredibly wasteful, especially when other blockchains like Peercoin exist which have been proven to drastically reduce the level of energy usage.

Geographical Centralization of Miners

Another problem concerning energy usage is the fact that most large miners operate in areas where there are low energy costs. Lower energy costs make it possible for miners to keep more of the profit they earn from block rewards. The problem with this is that it has had the effect of centralizing the majority of mining in countries where the electricity is inexpensive.

Centralizing mining power in a single country exposes those miners, and therefore the network itself, to the possibility of being targeted by that country’s government. This could include heavy regulations, shutting down mining operations altogether or even forced censorship of transactions. A truly distributed network like Peercoin has security providers that are spread globally, making it incredibly difficult to influence or shut down the network.

Diverging Interests of Miners & Users

It should also be noted that miners may not personally have the interests of the blockchain in mind when it comes to long-term development. Miners are first and foremost profit generating businesses. Their main priority is making money, therefore they may favor developments that may place them at odds with those who use the network (i.e. bitcoin holders). When considering technical improvements and upgrades to the network, for example, miners may want one thing while users want something else. The desires of both groups fall out of alignment, making governance and protocol rule changes difficult, even impossible.

This may even lead to situations where miners act against the development of the network, favoring short-term rewards over long-term growth. In a severe case where miners refused to upgrade to the newest version of Bitcoin, other validation nodes were forced to start rejecting their new blocks; this caused miners that refused to upgrade to lose block rewards. Validators across the network held miners hostage financially, forcing them into a situation where they had to upgrade in order to continue earning money to pay for their mining operations.

This ability creates a sort of separation of powers where block validators on the network can force miners to upgrade the blockchain to a new version by rejecting their blocks and not providing them compensation. A better model however would be if the interests of both users and miners were aligned so that many of the toxic community disagreements between different factions were reduced, however a model like this is impossible with proof-of-work.

This ability creates a separation of powers where block validators on the network can force miners to upgrade the blockchain to a new version by rejecting their blocks and not providing them compensation. A much better model however would be where the interests of both users and miners were aligned so that many of the toxic community disagreements between different factions were eliminated. A model like this, however, is impossible with proof-of-work; only proof-of-stake which Peercoin operates on.

7. Bitcoin’s Lack of Sustainability

There are rules coded into the protocol that govern Bitcoin’s supply. One of the rules is that only a maximum of 21 million bitcoin can ever be mined. Once the final block reward is mined, no more coins will be produced. Since block rewards subsidize costs so that miners have an incentive to continue producing new blocks, this rule has massive implications for the future security of the network. How will miners be compensated for producing blocks and security once the last coin is mined and block rewards come to an end?

Voluntary User Transaction Fees

The answer is that block rewards are not the only form of compensation that miners receive. Miners also receive transaction fees from users of the network in order to get their transactions included in the blocks that miners produce. So, miners are always receiving two forms of compensation: block rewards generated by the network itself; and fees paid by users of the network.

Users can pay any size fee they want. A user paying a larger fee provides financial incentive for miners to prioritize and process their transaction more quickly, but naturally most users will elect to pay a lower fee.

Block Reward Halving

Rather than coming to an abrupt halt, block rewards are designed to be phased out gradually. Instructions are coded into the protocol to automatically halve block rewards every 210,000 blocks, which occurs about every four years.

When Bitcoin first launched, the block reward for the first four years was 50 bitcoins. This amount was reduced to 25 after the first halving, then 12.5 and will continue to reduce in half every four years until it reaches zero. The last block reward will be mined around the year 2140, which provides a long transitionary period of many years for miners to switch from block rewards solely to user transaction fees.

The Tragedy of the Commons

Phasing out automatic network generated payments in favor of user provided transaction fees may sound great in theory, but the reality has turned out quite different. The major problem with this model is the tragedy of the commons, whereby individual users, acting independently according to their own self-interest, collectively exploit a shared resource contrary to the common good of all users. A commonly cited example of the tragedy of the commons is the collective destruction of the environment by self-interested individuals attempting to achieve personal economic success.

In Bitcoin, the common shared resource is the blockchain and the security of the network itself. Users have a personal financial incentive to spend as little on transaction fees as possible; however, this self-interest has the effect of damaging the very system that they operate in.

As block rewards continue to reduce in size over time, miner compensation increasingly needs to be made up with user transaction fees. Without an appropriate level of fee compensation by users of the network, miners will not be able to afford the massive costs associated with mining, leading to the eventual shut down of their operations as funding runs low.

Short-Term Behavior Sabotages Long-Term Security

While users do care about the long-term health of the network, their immediate concern is saving as much money in fees as possible. Unfortunately this normal and predictable human behavior works against the financial interests of the miners who secure the network for them. In the future, if voluntary user transaction fees are not enough to sustain network security in the absence of block rewards, then unprofitable miners will continue to drop out until a majority of the hashing power is controlled by just a few people or even one large mining pool, which will put the network at serious risk from a double-spend attack.

Therefore, it is realistic to ask whether proof-of-work consensus will remain viable as a blockchain security protocol. It may still be secure right now, but due to flaws inherent in the system, that security may not be sustainable in the long-term.

Price Dependent Security

Another factor to consider is the market price of blockchain tokens. Since Bitcoin miners are compensated in their native token (i.e. bitcoins), their profitability is dependent on its price. In times of price appreciation, miners don’t have so much to worry about because the coins they earn are sold for high valuations.

In times of price depreciation, however, the market may not value coins highly enough for miners to be able to pay their costs of operation. Proof-of-work network security is therefore dependent on the market price of blockchain tokens; this can put the network at risk if too many miners drop out because of unprofitability.

8. Scalability of Bitcoin

Bitcoin was originally designed by Satoshi Nakamoto as a digital replacement for cash. In fact the original whitepaper was titled Bitcoin: A Peer-to-Peer Electronic Cash System. This implies that Bitcoin has the ability to scale to a global level where everyone in the world has the opportunity to transact with the digital currency.

Time has shown, however, that blockchain technology is not capable of scaling to worldwide use alone by itself. An intense debate has been raging in the crypto community for some years about the best way to scale the blockchain to higher usage levels. The core argument is about whether to increase the size of blocks.

The Block Size Limit

One of the rules coded into the protocol is that the size of each block can be no more than one megabyte. Since blocks contain transaction data, blocks will fill as users increase transactions on the network. Once a block contains enough transactions to reach 1MB, no more transactions can be added to it. Any transactions over the block size limit must wait for the next block to be added.

At a 1MB block size, the Bitcoin network can only support about seven transactions per second, and this prevents the blockchain from being able to scale to support worldwide usage levels. One proposal in the Bitcoin community was to increase this limit, so that the blockchain can support a higher capacity of transactions per block. However, others in the Bitcoin community believe that this will further centralize the network.

Block Size Limit Increases & Centralization of Full Nodes

Remember that full nodes carry a complete copy of the public ledger. The blockchain itself is massive in size due to the requirement to store every single transaction that has ever been processed by miners. This massive ledger needs to be stored on the computer that the validation node is operating on.

If the size of the blockchain becomes larger than what a validator can store on their computer then they will be forced to upgrade their storage capacity in order to continue holding a full copy of the chain. If they do not upgrade then they won’t be able to store the entire ledger, which will prevent them from being able to perform validation of transactions and blocks.

If the block size was increased for example and the number of transactions increased along with it, one fear is that there would come a point in the future where there were so many transactions being performed on the network that advances in storage technology would not be able to keep up with and support the rate of growth in the size of the blockchain.

If this occurred and prices for higher capacity storage did not fall fast enough, it might become unaffordable for certain validators to be able to store the entire blockchain history on their computers. As the number of transactions increased per block, validators would need to continue upgrading their storage capacity in order to hold the entire chain.

This may lead to a situation where volunteers and hobbyists operating full validation nodes would have to quit because they could no longer afford the costs of upgrading their storage capacity. The number of full nodes would decrease over time due to the unsustainable growth of the blockchain and only those with enough resources would be left operating full nodes, namely large merchants, exchanges or payment processors. Once again we have another path that leads to centralization, this time affecting the number of full nodes that do accounting and verification work for the network.

However this possibility depends on how quickly storage technology advances and how affordable it becomes for the average person. It is possible that storage technology may keep up with the rate of growth in the chain size, but only time will tell. In the meantime, other more pressing issues exist with bigger blocks.

Validation nodes have the responsibility of relaying new blocks to other nodes in the network. However this process of propagating new blocks throughout the network will take much longer if block sizes start increasing, especially considering how unreliable internet infrastructure is around the world.

Bandwidth limits may also cause problems with propagating large amounts of data. Consider for example that many home internet packages have much lower upload bandwidth compared to the higher limits offered for downloads. Also remember that each new block takes about 10 minutes to produce. Once blocks become large enough they may reach a point where there is not enough time for each new block to propagate to the rest of the network before the next block becomes due.

Yet another problem is how validation nodes will process all this data. Research suggests for example that it will cost a considerable amount of RAM in order to process large blocks. Most people do not have access to the amount of processing power that will be required, which places the network in a position where volunteer nodes will no longer be able to participate. So both broadcasting and processing this level of data becomes a problem for the average user, placing the task of transaction and block validation mainly in the hands of larger entities that have the resources to continue operating full nodes.

2017 Bitcoin Chain Split

In 2017 the block size debate came to a head when the two opposing camps decided to split the network into two separate blockchains that each followed different rules. Both blockchains contained the same history of transactions, but diverged at the block where the split occurred.

One blockchain retained the 1MB block size and continued to be called Bitcoin. The second blockchain increased the block size from 1MB to 8MB and became known as Bitcoin Cash. Supporters of each network went their separate ways: Bitcoin Cash supporters following the philosophy of scaling with block size increases; and supporters of Bitcoin following an alternative scaling solution.

Developers on the main Bitcoin chain had a problem on their hands. The block reward halvings would eventually impact miner profits, so developers needed to solve this problem quickly or risk network security. Ultimately, developers intentionally chose to keep the 1MB block size limit for reasons that will become clear.

Transaction Fee Market

When the Bitcoin network is too congested with transactions and blocks are full, miners need to decide which transactions to include in a block. There is limited space available, so it becomes necessary to choose which transactions get priority. The Bitcoin network has a transaction fee market which takes over when blocks reach 1MB. When blocks are full, users realize that it will be difficult to get their transactions added to the chain, so they voluntarily begin to increase the transaction fees they pay to miners.

A higher transaction fee is more profitable for miners, so they will be more likely to prioritize transactions with higher fees over those with smaller fees. In this way users of the network enter a bidding war for the attention of miners. The highest bidders paying the largest fees will be the first ones to get their transactions included in new blocks, while the lowest bidders will need to wait.

Block Size Limit Solves Block Reward Halvings

Bitcoin developers realized that this transaction fee market was the solution to decreasing block rewards. Miners need to be able to stay profitable when block rewards are reduced, and so the only way to ensure miners are properly compensated is to create a situation where users are incentivized to pay more in fees. Bitcoin developers have brought this situation about by limiting the block size to 1MB.

With this artificial limit in place, as blocks fill up and transactions reach maximum capacity, users are incentivized to pay higher fees in order for their transactions to be validated by miners. If a user refuses to set a higher fee, then miners will likely pass over them in favor of others who pay higher fees. They may eventually get their transaction included hours or days later by a generous miner, but not everyone can afford to wait this long so in order to avoid the long wait times they will voluntarily raise their fee so they have a better chance at getting their transaction processed sooner.

This artificial block size limit therefore motivates users to voluntarily raise the transaction fees they pay to a profitable enough level for miners to be able to continue their expensive mining operations in the face of vanishing block rewards. In this way network security is able to be sustained for a while longer.

Block Size Limit Impacts Network Usability

This model solves the issue of decreasing block rewards so that miner provided security is retained, but at the same time it creates new problems. Bitcoin was originally designed as a peer to peer digital replacement for cash. By limiting the block size, this vision is no longer possible through use of the blockchain alone.

The Bitcoin community once advertised the blockchain as having lower fees than credit card networks. The implementation of a fixed block size limit means this advantage of lower fees is eliminated when blocks are full. When this does occur, users of the network are forced to pay exorbitant fees in order to transact.

While the block size limit solves the problem of decreasing block rewards, the resultant transaction fees will ultimately spike during extreme price rises; at the peak of a price bubble, network congestion is at its highest due to a fight over limited block space. This extreme rise in fees negatively impacts users by preventing them from making smaller transactions without significant cost. Not only does the block size limit increase fees to unaffordable levels during peak trading, but it also does not solve the scalability problem. A 1MB block size does nothing to support higher usage levels.

Bitcoin as a Settlement Network

Bitcoin developers however realized that it was not possible for the blockchain to facilitate worldwide transaction volumes, due to the block size limit, so they made plans for an alternative solution.

Rather than attempting to engineer changes into the blockchain that would eventually centralize it like block size increases, it became obvious to developers that the purpose of the blockchain needed to be refocused to that of a settlement layer for high value transactions.

Secondary Layers & Off-Chain Transactions

The purpose of the blockchain as a settlement layer is that secondary layer technologies can be built on top of it. These secondary or layer 2 networks are designed to take full advantage of the blockchain’s trustless security. They benefit the overall network by providing additional functionality that the blockchain is unable to perform by itself.

For example, some layer 2 networks allow users to make high speed transactions at low cost without needing to wait for miners to produce new blocks. This is possible because transactions that are performed on layer 2 networks exist outside of the blockchain.

Transactions performed directly through the blockchain are considered on-chain transactions. Transactions performed on layer 2 networks are processed off the blockchain, and are quick and inexpensive. On-chain transactions are stored in the blockchain history by a miner. Off-chain transactions are not stored in the blockchain history at all.

The Lightning Network & Payment Channels

The primary example of layer 2 technology is the Lightning Network, which was developed for Bitcoin. To begin, a user will make an on-chain transaction by first depositing some coins into a special address associated with the Lightning Network; the user then opens a payment channel which allows them to transact with other users of the Lightning Network. All transactions are performed off-chain and the Lightning Network keeps track of balances.

A user can perform as many off-chain transactions as they want. Finally, once a user is done making payments on the Lightning Network they finish by closing their payment channel. Closing a channel has the effect of settling by recording the final changes in balance on the blockchain.

In this way, the Lightning Network and other layer 2 solutions allow users to bypass expensive miner fees by performing the majority of transactions on secondary layer networks. The blockchain is used mainly to synchronize balances whenever a payment channel is closed and changes need to be recorded.

This is what is meant by the blockchain becoming a settlement layer. Transactions are conducted off the blockchain, thereby preventing the chain from bloating and growing in size too much. Off-chain transactions are periodically totaled and permanently recorded on the ledger.

Blockchain as a Base Layer

Lightning is only one example of a layer 2 network; another is PeerAssets, which is a layer 2 token protocol developed for Peercoin. There will be other examples as time goes on. Eventually features and improvements will build to the point where we will have layer 3 networks and beyond. All future layers remain completely dependent on the security of the base layer blockchain. Without a secure base layer acting as a solid foundation, everything built on top will be jeopardized.

Satoshi’s original vision - a peer to peer cash system where transactions are typically conducted on chain - is no more, at least with regards to Bitcoin. Developers have instead elected to focus on an alternate scaling solution that limits the amount of on-chain transaction volume.

Putting it all Together

Let’s summarize now to make sure we fully understand the reasoning behind the decisions of the developers.

A block reward is distributed with every new block, which compensates miners for the costly work they perform and incentivizes them to continue producing new blocks and security for the network. The block reward is on a set schedule where it will continue decreasing until it becomes zero. Voluntary user transaction fees are not a reliable replacement for block rewards because users are motivated to save as much on fees as possible. Bitcoin developers therefore instituted a 1MB block size limit.

As a result of this limit, when a block fills up with transactions, users are incentivized to pay higher fees to have a better chance of getting their transactions accepted by miners. These raised fees are profitable enough for miners to sustain themselves in the absence of block rewards. However these raised fees make it too expensive for normal users to transact on the blockchain.

In response, developers refocused the Bitcoin blockchain from a peer-to-peer cash system to a base layer settlement network. This base layer blockchain works in conjunction with other layer 2 networks such as Lightning, which makes it possible to perform lots of quick and inexpensive off-chain transactions. The high fees of on-chain transactions push users conducting micro-transactions off the blockchain onto these layer 2 networks where transactions are more affordable.

These developments accomplish a number of things. Miners receive their proper compensation to continue operating. Micro-transactions are off-loaded onto layer 2 networks, which makes fees cheaper and speeds faster for users and prevents the blockchain from bloating and growing too fast from too many on-chain transactions.

Any on-chain transactions will be high value transactions where the fees spent are marginal compared to the value that was exchanged. Layer 2 networks also finally make it possible for Bitcoin to scale to support global transaction volumes and usage levels. With layer 2 networks, the number of possible transactions is no longer limited by the block size.

Fee Competition Between Miners & Secondary Layers

One issue that remains to be explored is how the existence of layer 2 networks will impact miner profitability. Off-chain transactions on layer 2 networks do not provide any fees to Bitcoin miners. Only on-chain transactions do this. It would appear then that Bitcoin miners and layer 2 networks are in direct competition with each other when it concerns fees, maybe even incompatible.

However this is untested since layer 2 networks are still new and have not seen significant adoption yet. Some even argue that the low fees of layer 2 networks will actually attract more on-chain transactions, resulting in higher profitability for miners. Price is also a major factor. If bitcoin were high priced, miners may be able to remain profitable off few very expensive transactions, even when 90% of users are conducting off-chain transactions on layer 2 networks. The crypto industry is currently in unexplored territory and it remains to be seen how these new technologies will impact blockchain security.

What we can say for sure however is that Peercoin and proof-of-stake were intentionally designed without this conflict over transaction fees. Peercoin by design is not dependent on transaction fees for security, therefore it is 100% compatible with layer 2 networks. This will be fully explained later in the article.

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