Consensus Mechanisms, Rewards, and Wallets

10 min readMar 12, 2022

What is a consensus mechanism?

Who gets to decide what changes happen on the network? Who gets the rewards? who takes decisions?

This is where the consensus mechanism comes into play. As a blockchain network is decentralized and there is no higher authority to make decisions, there are a set of rules and regulations that are set in the whitepaper of a blockchain which helps to determine the legitimacy of transactions, who mines the next block? who gets the rewards, etc.

In order for the distributed network to work smoothly, all the nodes agree to these rules. This understanding between the nodes on the network to be in sync with each other and make decisions in a completely decentralized manner is called a consensus mechanism.

Let's take an example of one of the many possible consensus mechanisms,

You go to a hotel with a bunch of people and want to order food but aren't able to come to a conclusion. And let's say all of the members in the groups have an understanding that if the “majority” of the people agree to order a particular dish then it shall be ordered. Hence, all the members place a vote for every disputed dish and get it ordered based on your (majority) consensus mechanism.

In this way, there are multiple ways to formulate a consensus mechanism that helps a distributed network to collectively come to a decision that is acceptable by every node in the network.

Some commonly used consensus mechanisms

👉 Proof of Work (PoW)

This was the first used consensus mechanism to exist and was proposed by Bitcoin creator Satoshi Nakamoto in the whitepaper. (The working of this consensus mechanism was explained previously while explaining about Bitcoin, please refer to that)
This consensus mechanism is used by two of the largest blockchains, Bitcoin and Ethereum.
All mechanisms have their pros and cons, in PoW, the mechanism highly depends on the compute power therefore whoever sets up a large number of computers with high computing power (collectively called mining pools/mining farms), then they highly increase their chances of solving the puzzle first and getting the rewards. There are various ideologies to eliminate this kind of centralization. We’ll go into this deeply later.
Proof of Work uses the highest amount of energy when compared to other consensus mechanisms because of its dependency on computing power as an index of consensus.
Because of Bitcoin’s high energy & computing power requirements, it is now mainly used for financial transactions or as a store of value while Ethereum on the other hand was developed as a general-purpose blockchain with the support of DApps which users use frequently. Therefore because of the high usage of Ethereum for decentralized applications, it had to be scaled with a more user-friendly and environment-friendly consensus, hence it is being migrated to PROOF OF STAKE (Ethereum 2.0)

👉 Proof of Stake (PoS)

Proof of Stake was the alternative that was proposed in place of proof of work to provide speed and scalability while maintaining security and decentralization.
Staking means locking up one’s network tokens/coins as collateral for making sure they do not perform any malpractices on the network as nodes.
In the proof of stake mechanism, the nodes are asked to stake a certain amount of minimum number of network tokens (as mentioned in the whitepaper) to be recognized as one of the nodes on the network.
Unlike proof of work, proof of stake doesn't need high computational power to be selected as the winning node to mine the block and get the rewards, a node with one of the highest stakes on the network is randomly selected in order to have a probability relative to their staking capital to get a chance to validate the transactions and collect the rewards.
The rewards for mining and validation in proof of stake are relative to the amount of capital (network tokens) you stake.
On the other hand, if your node is found to be biased while validating transactions or is found to perform unacceptable activities on the network then the stake of that node is taken away and removed for the circulating supply of network tokens.
The process of punishing the nodes by taking away their stake for suspicious validation activity on the network is called SLASHING.

*circulating supply: the total amount of tokens that all the users on the network hold.

What are the rewards that nodes(miners) on a blockchain network get?

👉 Block Rewards: Paid to miners for generating a new block.

👉 Transaction Rewards: Paid to miners to incentivize transaction verification/validation.

👉 Gas Rewards: Same as transaction fees but paid by the smart contracts.

What are network tokens?

👉 In order to make transactions more scalable and easier like we do in the current financial system with the use of currencies, Blockchain transactions can be made with the help of the native tokens of the chain.

👉 These tokens can be used as a store of value, to make purchases, mining and validation rewards for miners/nodes or they can trade tokens just like other securities to make a profit.

👉 Tokens are built on a blockchain to make on-chain transactions better and more reliable.

👉 Just like an IPO in the share market, tokens in a network are offered as ICO (Initial Coin Offering)

👉 Instead of the blocks holding every single transaction data, the tokens hold the transaction data.

👉 The ICO for the users to perform initial transactions as an opening ledger token balance on the network is called the coinbase and all transactions in the network using the tokens are then backtracked to the coinbase to validate the balances of each transaction.

Coinbase in detail

(This isn’t Coinbase-the wallet/exchange)

Think of coinbase as a way to put the tokens in circulation for people to use it. In order for transactions to happen on a network, people have to hold some tokens of that network. A person can get tokens in only the below-stated ways:

Mining Rewards — possible only on mining a block. People mine blocks on a chain only when they find that they have good rewards which depend on the adoption of the chain — basically the number of people using it (transactions)
Validation rewards — tokens received as rewards Validating transactions & gas fees.
Airdrops — Tokens are given away to early adopters of the network (Giving away is also a transaction)
Coinbase — 1, 2, and 3 scenarios are only possible when there are actually some tokens available in a wallet/smart contract that decides to do the activities stated in the above 3 steps. And hence for tokens to be available for smart contracts to provide rewards or for people to give airdrops, there has to be some initial amount (Similar to how you need the government to print the money and give it to the banks to put it in circulation) available right? These X tokens as the initial transaction is called a Coinbase which decides a certain wallet/smart contract would have X amount of tokens which would be used to distribute tokens in the network and then further can be used by network adopters to perform network transactions.

*Smart contracts: an automated set of immutable rules written in code that execute independently without the need for a human to control it.

But there are a lot of tokens, how do they coexist?

👉 There are a lot of tokens available on various chains, so in order to maintain a certain sort of standard so all the newly developed tokens are developed accordingly.

👉 This standard is called the ERC20 token standard.

👉 This standard was introduced when there were a lot of crypto tokens and projects being introduced in this space. Hence, as Ethereum’s ETH token was developed before the ERC20 standards were formulated, ETH doesn’t fall under the ERC20 compliant standards. In order to make ERC20 compliant and coexist/interact with other tokens, wETH (Wrapped ETH) which is an ERC20 compliant version of ETH was developed.

Where do I hold these tokens though?

👉 In order to hold your tokens, you require a wallet similar to how you hold currency in the current financial world.

👉 Crypto wallets use public keys — an address that everyone on the network can see and use it to send tokens to you or view your token holdings and private keys which only you will be knowing. Private keys are used by users to sign (authorize) transactions

Note: Wallets hold only public and private keys. They do not store any sort of “balance tokens/wallet balance”. Every time you open a wallet the system then backtracks all the transactions on the network up until the coinbase to determine/calculate what your wallet balance would be.

👉 There are two types of wallets available to hold crypto tokens:

Non-custodial Wallets: Wallets that are completely in control of the token holder. These kinds of wallets are the safest to hold your tokens on as they are completely decentralized and the wallet’s private key is in control of the holder. There are 3 types of non-custodial wallets, Hardware wallets, web-based wallets & mobile wallets, Desktop wallets. The user has the private keys of these wallets encrypted and stored with access to no one but the user. The only possibility to get robbed with these wallets is to willingly login into a phishing/malicious site.

Examples for Non-custodial wallets

👉 Metamask: a web browser extension and a mobile application. (Popularly used)

👉 Ledger: one of the many hardware wallets where the token is stored and disconnected from all the malicious attacks on the internet until connected back to a PC next time.

2. Custodial Wallets

A wallet that is provided by a centralized company/organization to hold your tokens is called a custodial wallet. A custodial wallet is a lot less secure when compared to the non-custodial wallets because the company/organization providing you the wallet has access to all your tokens and your private keys. Such wallets are centralized and have more chances of breaches and malicious attacks. The security of these wallets is completely dependent on the security measures taken by the wallet provider. Some popular examples are,

3. Paper Wallets

👉 This is basically you storing your wallet's private keys by writing them on a piece of paper and typing them in every time you try to make a transaction.

👉 The wallet’s private keys do not exist on the internet and hence the wallet is relatively more secure from attacks.

👉 The only way to lose your tokens in these kinds of wallets is to lose the paper on which you’ve written your private keys.

Some fundamental points to take away about this technology

👉 Blockchain and cryptocurrencies help users make transactions independently.

👉 The decisions about the transaction network is made collectively by the network users in a decentralized way (There is no “owner” or “monopoly” to listen to)

👉 The network awards its validators for contributing to the network while punishes them for suspicious activities or non-compliant behavior (based on the consensus mechanism)

👉 Tokens are used as assets/medium to store value and make transactions.

👉 Tokens are encrypted and secure. They are initially provided to the early network users as ICOs or given to the early network adapters as airdrops into their wallets. Once the Coinbase is in circulation, new tokens are unlocked in stages based on block mining, rewards, and usage.

Crypto adoption over the years

(Source of the chart)

Adoption to crypto has been parabolic over the past few years. People moving from web2 to web3 because of various parallel decentralized solutions that project teams in this space provide. For example:

👉 Projects like AAVE on Ethereum or Anchor Protocol on Terra provide a seamless decentralized alternative to banking activities in the crypto space.
👉 Projects like UNISwap on Ethereum provide decentralized token (currency) exchange.
👉 Projects like Opensea provide a decentralized marketplace for NFTs.
👉 Chains like Terra or Ethereum are dedicated to bringing Defi (Decentralized Finance) and many more decentralized applications to the users.

Some keynotes for the community, believers, and aspirants

👉 Crypto space has been booming a lot ever since we decided to make Peer to Peer transactions decentralized and inflation kicked in for the centralized world economy.

👉 There has been a huge parabolic growth in this space over the past 2 years ever since the pandemic started and large world economies faced huge % of inflation and unemployment.

👉 There is a lot of upside for this technology and space but remember it takes patience. Price action for the tokens isn't something that decides if a project is good or bad.

👉 Irrespective of who you are, whether a developer or an investor, always look for projects that have a real-world use case and not a project which has grown parabolic in terms of token price.