How Does Cryptocurrency Work?
Cryptocurrency is a complex system that enables decentralized, anonymous, and secure financial transactions using blockchain technology. But how does that work? Read to find out.
Cryptocurrency refers to the internet-based medium of exchange which uses cryptographical functions to conduct financial transactions. Cryptocurrencies leverage blockchain technology to attain decentralization, transparency, and immutability.
The vital revolutionary properties of cryptocurrency are illustrated in the figure below.
How Do Miners Create Coins and Confirm Transactions
Transaction in Cryptocurrencies
Cryptocurrencies like Bitcoin are made up of a network of peers. Each peer has a record of the complete history of all transactions and the balance of every account. Let’s take an example to better understand how this works. A transaction is a file that says, “Alex gives x amount of Bitcoin to John” and is signed in with Alex’s private key. This is the primary public-key cryptography. After signed in, the transaction is broadcasted in the network from one peer to every other peer. This represents the basic p2p-technology used in cryptocurrencies. The figure below illustrates the transaction process in cryptocurrency.
Blockchain and Cryptocurrency
The transaction that takes place is known to the whole network immediately. However, this happens after some time has passed since the transaction is confirmed for security purposes. In cryptocurrencies, confirmation is the most crucial. Some could even say cryptocurrency is all about confirmation and what gets saved in the database since it is entirely digital.
A transaction can be forged when it is unconfirmed/pending. However, once the transaction is confirmed, it is set in stone, becoming a part of the immutable record of historical transactions known as Blockchain. This means that the transaction cannot be forged or reversed.
How do transactions get confirmed?
This is the job of cryptocurrency miners. They take transactions, stamp them as legit, and spread them in the network. Once the transaction is confirmed by a miner, each node in the system adds the transaction to its database, becoming a permanent part of the blockchain. In exchange for this service, the miners receive a token of the cryptocurrency, which can be perceived as the transaction cost for trading in cryptocurrencies.
Cryptocurrency mining is the single most crucial part of the cryptocurrency system. Although becoming a miner seems like a hard job to get, it is quite the opposite – anyone can become a miner. This is because the cryptocurrency network is decentralized. Therefore, there is no authority to delegate this task. However, this signaled a threat to the system because the miner could abuse this power.
Therefore, Satoshi Nakamoto, the unknown inventor of Bitcoin, set a rule where miners are expected to invest their computers in becoming a miner. To be more precise, the miners need to find a hash (this is a technical term used to refer to a product of a cryptographic function). This becomes known as the Proof-of-Work. In Bitcoin, this is based on the SHA 256 Hash algorithm.
Don’t be disheartened if you do not understand the technical words. All you need to understand is that this is the basis of a cryptologic puzzle which the miners compete to solve. Once the miners have found the solution, they can build a block and add it to the blockchain. As an incentive to finding the solution, the miner has the right to collect a coinbase transaction, which gives the miner a specific number of Bitcoins. This is the only way to create valid Bitcoins.
However, the puzzle’s difficulty increases the amount of computer power the whole miners invest. There is only a specific amount of cryptocurrency tokens, which can be created within a certain period. This is a consensus that no peer in the network can violate.