Consensus algorithms are the lifeblood of all crypto technologies. However, traders and holders generally pay little attention to them as they are considered irrelevant to the price of an asset. But this is not accurate. Consensus algorithms play a huge role in the value of a coin or token. Let’s take a look at how and why this happens, and why you should care.
Consensus Algorithms are all about Trust
Firstly, let’s take a look at what exactly a consensus algorithm is. In a nutshell, they are a process that computers use to agree on how something should be handled. In cryptocurrency, a consensus algorithm is simply a method of adding transactions to a blockchain.
There are dozens of different consensus algorithms in the market, but only two are truly popular: proof-of-work (PoW), and proof-of-stake (PoS). Popular PoW cryptocurrencies are Bitcoin, Litecoin, Dogecoin, and Monero. Popular PoS cryptocurrencies are Polkadot, Cardano, DASH, and Tezos. Ethereum will also soon become PoS after its ETH 2.0 upgrade (scheduled at some point this year or next), however at the moment is PoW.
PoW is the first consensus algorithm to ever be used in the crypto world, first showcased by Bitcoin. This makes it the oldest and most trusted algorithm in the market. Generally, people view PoW coins as more trustworthy because the technology behind them has been more heavily tested and is better understood. Because PoW coins use electricity and computer processing power, a successful PoW project is harder to create, as it requires a reasonable amount of miners who are all dedicating their time, resources, and finances, to help the blockchain run. For this reason, there are fewer PoW scam coins and copycats in the market, as opposed to PoS, which only requires people to lock up their finances onto a blockchain (known as “staking”).
However, PoW is not without its drawbacks. The biggest of which being that it uses a tremendous amount of electricity. Earlier in the year, Elon Musk tweeted that PoW coins utilize far too much power, and are having a negative impact on the environment. When he did this, the price of most PoW coins dropped significantly. This is one reason why Etheruem is switching to PoS.
Experimental Consensus Algorithms
As the industry matures, more and more developers are trying to build projects that stand out from the crowd and distinguish themselves as unique. One way to do this is to engage in newer and more experimental consensus algorithms. For instance, Idena uses a “proof-of-person” blockchain, which is where humans must actively validate the blockchain by actively performing tasks on the blockchain, and Solana created “proof-of-history”, which is an algorithm that uses timestamps to designate changes.
It is hard to evaluate what makes a good consensus algorithm, especially when they are experimental (and if you don’t have a background in computer science). If you choose to invest in coins like this, be vigilant and try to see if there are any documents or scientific papers that have been published focusing on its algorithms. These papers can be tough to navigate, but their conclusions and introductions are often easily digestible. What you should look for is any reason to doubt the strength of these concepts.
A coin with an experimental algorithm may do well in a bull market, but in times of hardship, it could drop like a rock. This is especially true if they launched during a bull market, as their novel aspects will eventually wear off on the public.
Why does this matter (from a lending perspective)?
For starters, bear in mind that the consensus algorithm of a coin oftentimes determines whether a lender will even accept it as collateral. DeFi lending platforms require your coins and tokens to run on a similar blockchain that the project itself runs on. There can be exceptions to this (such as cross-chain projects), but these are mostly still in their early stages of development.
Generally, however, most CeFi lenders can accept coins of any algorithm (but it is best to check with them beforehand). One issue that can sometimes arise is that coins with unusual consensus algorithms can be tricky to store in a cold wallet (which is the norm for services like Helio). Cold storage wallets are usually only made for the most popular consensus algorithms, such as PoW and PoS.
Keep all of this in mind when looking at experimental and unique projects, as the collateralization process can get complex, depending on the underlying technology being used.
https://heliolending.com/2021/09/10/how-consensus-algorithms-affect-the-value-of-your-assets/
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