This article explains what a digital asset or crypto validator is, and what incentives are provided to validators for the long-term. Validators are imperative to the operation of many popular networks.
Validators Simplified
In simple terms, a validator checks for the correctness of a portion of code or document [1]. Validators have been used outside of crypto for decades ensuring accurate data streams/information by using computer algorithms. In crypto this concept is taken to another level by intertwining the validator incentives and functionality with the ecosystem and tokenomics. Each crypto network has its own mathematically based ecosystem and built-in economics, some are more fundamentally strong than others. This is one reason that Bitcoin continues to lead the charge, it simply has some of the strongest fundamentals.
Bitcoin validates transactions with tens of thousands of individual nodes. A node is simply any computer or “rig” that runs Bitcoin operations, while also storing the entire history of Bitcoin transactions [1]. Bitcoin nodes can be viewed as referees of the Bitcoin blockchain, credit to this analogy to River Financial. Nodes essentially enforce the rules and settings for the entire network. Once the rules and settings are set, these rigs validate new blocks as they are created. Whenever a new block is going through validation, many peer-to-peer nodes check the blockchain for accuracy, this is what makes Bitcoin so safe. The more validators present, the more decentralized (lack of a primary controller) Bitcoin becomes.
With each new block, validators can confirm the correctness of a transaction without revealing the party involved, this is where the word “trustless” comes into play. Imagine you want to take out a loan, these days it can be a painful experience getting credit score checks and validating all your personal information on repeat. With blockchain technology, if you have the collateral present, be it your credit score or assets under ownership, loans can be taken out peer-to-peer without a bank or conflict of interest. These loans can also be given out semi-privately, the loaner would only know your wallet address with no personal information. Bitcoin can even take validation offline, using radio technology, mesh networks and satellite connections[1].
Consensus Mechanisms
Every network has what is known as a consensus mechanism. Consensus is simply agreeing on the same accurate data peer-to-peer. For a network to remain valid and safe, consensus assists with security by preventing a takeover of the network. To take over most networks, 51% ownership would be needed, this is why each new validator adds increased security to a network. A Bitcoin attacker would need to control 51% of an already greatly decentralized network to produce malicious blocks, this is nearly impossible at this point.
The two most popular mechanisms for consensus are proof of work (example: Bitcoin and currently Ethereum) and proof of stake (example: Cardano and Polkadot) [2]. Bitcoin uses proof-of-work, which does use a large amount of energy. This is because the computers have to run at high percentages to complete the algorithms to form new blocks. A benefit of this process is that it is more of a “mine to play” mechanism, proof of stake can be “pay to play”. For proof-of-stake, large investors can take over massive portions of the network by simply buying massive amounts of a given token and setting up a validator node. To combat this, protocols must be creative with their tokenomics, capping off validator maximums along with other strategies.
But why validate for a network?
Why Validate?
Continuing the Bitcoin example, validators are rewarded with Bitcoin by providing the “work” to keep the Bitcoin network afloat. The biggest cost for a Bitcoin validator is the initial cost of the computer hardware, and then the energy cost moving forward. Miners are highly incentivized to use cheap, renewable energy sources. Bitcoin blocks are created about every 10 minutes. Over-time less Bitcoin is awarded per block, currently 6.25 Bitcoin are created with each block, at current down-market prices, this is about 187,000$, nearly 26 million dollars per day are mined [3]. Bitcoin miners who can afford it will hold on to some or all of their Bitcoin, awaiting higher prices per coin. Many intelligent investors follow what Bitcoin miners are doing closely when deciding when to buy in or sell BTC. Ethereum currently uses a very similar consensus mechanism with miner rigs.
The difference with Ethereum is that it is currently testing a future network upgrade to move to proof-of-stake. This change will allegedly reduce energy demand by 99%, the consensus mechanism will change to validate transactions without the heavy proof of work energy costs. ETH stakers will be incentivized with a portion of transaction fees, and a standard APY in more ETH tokens. In down markets, only the already established miners who have invested into expensive hardware rigs and power setups make moderate profits. Proof of stake will remedy this somewhat by removing the barrier to entry of specific hardware and other technology. However, the minimum tokens needed for many networks can cost several hundred thousand dollars. Remember to stay safe out there, none of this is financial advice. Stay tuned for more articles coming this week, thank you for reading!
[2] https://ethereum.org/en/developers/docs/consensus-mechanisms/
[3] https://www.bankrate.com/investing/what-is-bitcoin-mining/
