Last week, we explored the basics of blockchain, the engine of cryptocurrencies. Now, we move on to the next layer in the chain. Since blocks can be added one after another in the blockchain, the next logical question is who adds blocks and how the blocks are added.
A transaction can be added to a block only after someone verifies it. But who verifies is a million-dollar query. In centralised institutions such as banks or financial institutions, bank officials verify each transaction. But in cryptos, transactions operate across a decentralised network and are verified by participants known as miners or validators, based on the blockchain’s consensus mechanism.
Blockchains are decentralised, with no central authority. Therefore, the network requires a method by which all participants reach an agreement on the “truth” of the ledger, that is, the validity of the transaction. This is called a consensus mechanism, and it is via this process that the blockchain network decides which transactions are valid and can be added.
In cryptos, there are many such consensus mechanisms. However, the most popular ones are Proof of Work (PoW) and the Proof of Stake (PoS).
In PoW blockchains, the miners compete with one another to solve complex puzzles, using powerful computers called nodes. Mining is like Sudoku, but quite a complicated and complex puzzle. Whoever succeeds in the puzzle earns the reward and adds the new block. The process of mining needs significant computing power. This ensures the transactions are verified, only those valid are added to the block, and the blockchain remains secure. In PoS systems, validators are picked based on how many coins they “stake.” Staking is like keeping money in a safe. The more you stake, the higher the chance of being selected. Honest behaviour earns a fee or new coins; dishonest actions result in losing the staked ones. The two mechanisms ensure that fraudulent transactions are prevented and the network is safe and secure. Moreover, they incentivise participants.
What to check
“So, what should you check before investing in cryptocurrency?”
It’s not enough to consider merely the PoW or PoS mechanisms. There are other crucial factors to look for. These include network safety and security, viz. strong and decentralised network with active nodes which cannot be easily compromised. Next, the speed of transaction and the fee, because these two directly affect the usability of the coin. Next, market reputation, that is, the coin’s history, community and development transparency.
Next, consider whether the coin addresses real-world problems and how it could be adopted. Only coins with practical applications tend to sustain value. Above all, consider the volatility of the coins as crypto prices swing wildly. Considering these aspects, in addition to the manner in which the blocks are verified, validated and added, helps investors take informed decisions and avoid hype-driven projects.
Types of currency
There are many types of cryptocurrencies. Bitcoin is the first and most famous. Altcoins such as Ethereum and Solana offer smart contracts and real-world applications. Stablecoins such as USDT or USDC are pegged to real assets. Tokens for utility or governance; meme coins, driven by hype and community and a few others aiming at solving real-world problems of finance, supply chains, gaming etc.
For long-term investments, coins that solve real-world problems, or have practical applications and could be easily adopted are generally more valuable than hype-based coins.
Caution: Cryptocurrencies might offer huge potential, but don’t lose your hard-earned money to a game of chance. Understand the concepts, do your research, make informed decisions, and invest wisely.
(The writer is an NISM & CRISIL-certified Wealth Manager and certified in NISM’s Research Analyst module)
