How are cryptocurrency transactions validated?

Recall that blockchains are distributed databases where all the transactions executed on a crypto network are recorded permanently. Every block of transactions is linked together chronologically in the order the transactions were validated.

Because it is impossible to set up a central authority or bank to manage blockchains, crypto transactions are validated by nodes (computers connected to a blockchain). So the question is: How do these networks ensure that node operators are willing to partake in the validation process?

The only way to guarantee there will always be individuals willing to invest their time and computers in a blockchain’s validation system is to introduce incentives to do so.

With incentives, validators are encouraged to participate actively and honestly in the validation process to earn rewards in the form of newly minted (created) cryptocurrencies. This incentive system sets the rules that govern the process of picking validators who would, in turn, verify the next batch of transactions. It also ensures that the activities of the validators align with the goal of the network as a whole. Validator nodes found to be involved in actions that undermine the validity of the crypto network can be barred from taking part in subsequent validation processes or punished accordingly. These incentive infrastructures are also known as consensus protocols.

There is a wide range of consensus protocols being used by existing blockchain networks. The two most common ones are:

1. Proof-of-work (PoW): This incentive system is a computer-intensive consensus protocol that requires validators (known as miners) to compete using expensive equipment in order to generate a winning code that grants them the right to add a new block of transactions to the blockchain. Once they add a new block of transactions to the blockchain, miners receive newly minted cryptocurrencies known as “block rewards” as incentives. Any fees attached to the transactions they include in the new block is also given to the successful miner. Crypto networks that rely on PoW mechanisms include Bitcoin, Dogecoin and Litecoin.
2. Proof-of-stake (PoS): This is a less energy-intensive alternative to the PoW protocol. Here, node operators don’t need to spend a considerable amount on specialized mining equipment. All they need to do is deposit (or lock away) a particular amount of coins on the blockchain to show their commitment to the well-being of the network. The protocol then picks randomly from the pool of nodes that have staked their funds and assigns them different tasks. For their troubles, the protocol rewards successful validators with newly minted crypto tokens. Crypto networks that use this system include Cardano, Ethereum 2.0 and Polkadot.