Cryptocurrencies from the Inside Out

July 1, 2018 10:30 AM
Advanced Technique

Proof of Stake is the Future 

The method that is used in bitcoin and many other cryptocurrencies to mine/process transactions is called proof-of-work: the work of finding a valid hash. 

Another competing concept is called proof-of-stake, which is an alternative to reaching a consensus for the blockchain. It was proposed by a bitcoin talk forum user in 2012 because proof-of-work required too much electricity and energy, and miners felt that mining a single block was a waste of resources. Also, a few studies have suggested that running and maintaining proof-of-work networks is as costly as powering millions of homes in the United States. Alternatively, proof-of-stake is a much more user-friendly (and environmentally friendly) alternative to proof-of-work.

In this type of consensus model, the number of coins stored in your wallet is what matters. The more coins you have, the better your chances that you will not breach the system because you have a vested interest in keeping it running. In proof-of-stake, blocks are not mined, but rather forged or minted. The participants who have a significant stake in the system get selected pseudo-randomly for forging and then adding blocks onto the blockchain.

This selection progress is random but weighted based on the number of coins you are staking. This will allow smaller stakers to also be selected, so all stakers have a vested interest. This is done by applying other factors such as how long has the stake been parked. Proof-of-stake is generally applied to those cryptocurrencies that are pre-mined so that users have access to the coins for staking. This means that the supply of proof-of-stake cryptos are fixed from the start and there is no block mining or forging reward like with proof-of-work.

The only incentive proof-of-stake forgers have is the transaction fee attached to that block. Some of the crytocurrencies using proof-of-stake are dash, neo, cardano and neblio. Proof-of-stake will be the future of handing transactions for a blockchain because of the scalability of the hash rate and the use of power to continue this process. 

Transactions & UTXOs

Transactions are money orders to the Bitcoin network that reassign value from one owner to another. To that end, transactions reference pieces of bitcoin in the inputs and reassign this value to recipients in outputs. When the transaction is accepted on the network, the pieces of bitcoin referenced in the inputs are spent and new “unspent transaction outputs” (UTXO) are created according to the transaction’s outputs. UTXO are how every participant in the network keeps track of where the money is in the network. UTXO are not only created for change, but any time a transaction defines a recipient. UTXOs are spent whenever they get used as a transaction input. However, even so the transaction remains part of the blockchain and everyone can look up later where the transaction output was created and (eventually) spent.

Therefore, after a UTXO is spent, it’s still a transaction output (TXO), but no longer a UTXO.

“How it works” (page 72) shows four unspent transactions that add up to 1.8 bitcoin. Let’s suppose you want to buy a car for 0.5 bitcoin. We would take one or more UTXOs and use them as spent transactions. 

There is no ledger that has the amount in anyone’s account, we need to take the copy of the blockchain and calculate those amounts. This is how a cryptocurrency wallet works. 

When we open a bitcoin account or wallet we have a private key. We keep this to ourselves and we also must make sure we don’t lose it or we will lose our coins (see “Keeping it secure,” below). 

Here how this works. The private key can generate a public key. The public key is what we give people who are sending us money. If we want to send someone else money, we can use the public key or the bitcoin address, which is the SHA256 hash of the public key. We only need to give people sending us money our public key. 

The private key is used to create a message and a signature. This message and signature can be decoded and verified as valid by using a validation function, which requires the public key input. This is how we know a transaction is valid and can be charged against our unspent coins. 

What is Smart About Smart Contracts? 

Now that we understand the basics let’s talk cryptocurrencies. Bitcoin might be the most popular, but there are thousands of cryptocurrencies, and dozens that deserve further scrutiny. They normally break down into two groups; platform coins, like ethereum, neo, cardano, stellar and nebio. These coins are used to do things on the network for that platform. Then we have tokens. Tokens are projects built on top of a given platform’s technology. The most popular are EC2 tokens, which are built on top of ethereum. 

Why does all this matter? Some of the blockchain platforms like Ethereum and Neo have shown to be good investments. The blockchain makes it easier to understand price action of these platforms. For example, ethereum is down about 50% from Jan. 16 through April 16 compared to only a drop of 30% in bitcoin. Once you understand the process of an ICO with an EC2 token, you can understand what is actually happening. Many large ICOs offered in 2017 are now maturing and coming online. When these ICOs like EOS were offered, they exchanged their new tokens for large amounts of ethereum during the ICO. Now they are doing a crypto version of a stock buyback and buying their coins and selling the ethereum they are holding. 

This is only one issue you will need to understand before attempting to trade cryptocurrencies, or derivatives based on them. In future articles we will discuss how to trade this new asset class and determine if classical technical trading methods apply to cryptocurrencies.   

 

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About the Author

Murray A. Ruggiero Jr. is the author of "Cybernetic Trading Strategies" (Wiley). E-mail him at ruggieroassoc@aol.com.