Proof of Burn and the Counterparty Approach

Friday 11 April 2014

Bitcoin uses a proof-of-work system to generate new blocks to be added to the blockchain. This process also serves to release new ‘coins’ into the system, as a reward to ‘miners’ for their computational effort.

The concept is at the core of the protocol and the economic incentives that underpin the system. The process itself is arbitrary, existing purely as a task that is both difficult to perform and easy to verify.

Since bitcoin we have seen a proliferation of so-called ‘alt-coins’. These are cryptographic token systems that take the underlying blockchain technology and experiment in various ways.

Most experimentation involves playing around with the algorithm for mining and block-generation. By example, the leading ‘alt-coin’ by market cap, litecoin, alters the proof-of-work algorithm, replacing SHA-256 with a more memory-hard function: Scrypt.

Doing away with proof-of-work

Interestingly, some ‘coins’ have done away with proof-of-work altogether. So called ‘proof-of-stake’ systems, such as peercoin, generate new blocks and secure the network by requiring users to show ownership of a certain quantity, rather than run hashing algorithms.

Experimentation is good. Given the open nature of bitcoin’s architecture this will no doubt continue around all aspects of the protocol.

With the development of meta-layers on top of bitcoin’s blockchain we have seen further innovations. These routinely do away with the computational power requirements of mining altogether, piggy-backing on bitcoin’s existing infrastructure.

Mastercoin is one such project. Mastercoin is a meta-protocol layer with token creation and distribution through a fundraiser style model.

Essentially users sent their bitcoins to a cryptographic address and, based on a prescribed set of rules, they were issued with Mastercoin tokens in return. So, there was never any ‘mining’ involved in the creation and distribution of the protocols native tokens.

In this spirit of innovation we now have the so-called proof-of-burn approach. Its use in the Counterparty system has bought it into the limelight. The native unit of the Counterparty system is the ‘XCP’. This distributed system, like Mastercoin, is built on Bitcoin’s blockchain.

counterparty

Proof-of-burn

Generally speaking, in a proof-of-burn, a cryptographic address is established with no private key. A participant sending their bitcoins to this address is issued with a proportional amount of XCP.

The bitcoins themselves are trapped at the receiving address, forever. Given they are unrecoverable, they can essentially be considered as ‘burned’: lost forever. This represents a sacrifice of value on the part of participants in order to partake in the new system.

Adam B. Levine of Let’s Talk Bitcoin likened the approach to “when the Spanish got to the new world and burned their boats.” In this analogy he goes on to note that “everybody was in the same situation […], nobody is getting rich off this unless we all get rich off this.” This is essentially the ethos that goes into the proof-of-burn concept.

On the face of it, the approach may seem foolhardy. The ‘burned’ bitcoins represent value that could have been spent on development. On current exchange rates Counterparty burned over one million US Dollars worth of value!

However, through this distribution model Counterparty eliminated any doubt about the intention of the developers.

Like Mastercoin, Counterparty is a protocol layer on top of the Bitcoin network. Bitcoin miners are paid small fees to register Counterparty transactions in the Bitcoin blockchain.

Value of the Counterparty Protocol

Counterparty instantly benefits from Bitcoin’s trusted and computationally powerful network. However, unlike Mastercoin, it is more difficult to question the motivations of the founders under such a scheme. It also eliminates the trust issues that arise with large sums of money endowed to a small group and the centralisation that necessarily follows.

The stated intention of the Counterparty protocol is to provide benefit for the wider Bitcoin community that exceeds the value of the burned bitcoins. The motivation is certainly there, with developers out of pocket bitcoins and left only holding tokens for the new system.

The utility of the proof-of-burn concept remains to be seen. Nevertheless, it will be interesting to see how the Counterparty project evolves and whether other protocols decide to adopt a similar approach in their systems.

Tristan Winters


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