What is exactly a cryptocurrency (crypto)?
Cryptocurrency is a digital medium of exchange, where coin ownership records are stored on a digital (cryptographically secure) ledger. This ledger is in point of fact a computerized secure database for transaction records. It is also used to monitor the creation of additional coins as well as to authenticate coin ownership transfer.
It is important to remember key points concerning cryptocurrency, in order to understand how it works:
- Cryptocurrency is completely digital, i.e. it does not exist in physical form;
- Cryptocurrency is decentralized, i.e. it is not issued by any central authority;
- Because of this decentralisation, cryptocurrencies work by means of a distributed ledger technology (blockchain) and can be traded through trade platforms like https://diemexplorer.com/.
How does a blockchain differ from a regular database?
A blockchain, unlike “regular” databases, stores its data in blocks that are chained together (hence its name!) This method allows it to create an irreversible timeline of data in a decentralized manner. When a block is filled, its data is “set in stone”, becoming an integral part of this timeline. Moreover, each and every block in the chain has the exact same timestamp.
How do cryptocurrencies work?
Once a digital currency is created, the question is “How do you obtain some, and how do you use it”?
Another question is “How can we eliminate the risk of fraud and manipulation”?
This is where mining comes in.
Each block on the chain must be validated by users all across the network prior to being added at the end of the chain; every user has his own copy of this public ledger, which is constantly updated.
Crypto mining is done by solving very complex computational math problems; these problems cannot be solved manually, and require expensive and incredibly powerful computers.
Crypto mining is essential for the maintenance of the transactions ledger upon which the currency is based. It serves two purposes:
- Producing new coins;
- Making payment networks – like First for example – more trustworthy and secure through validation of its transaction information.
Miners are responsible for confirming all the transactions inside a new block, so the block can be sealed and recorded on the public blockchain ledger.
For a block to be confirmed, miners have to compete with one another to make a “hash” (An algorithm to convert letters and numbers into a fixed-length encrypted output). It is made of:
- The transaction data inside the confirmed block;
- The product of complex mathematical formulas;
- The hash of the precious block on the chain.
Once a miner has completed a hash, a new block is thereby confirmed, and the hash is stored beside it. Miners receive new coins of the network’s currency as a reward for mining each new hash.
In order to prevent inflation, the currency supply must be regulated. To do that, the Blockchain protocol makes it progressively difficult to create hashes and / or confirm new blocks as the network grows.
Cryptocurrency transactions constitute, at least for now, the main activity of the blockchain world. Everything we hear about a coin’s value, market cup, crypto exchanges, (and even hacking and fraud) stems from crypto transactions.
So how does this work?
A crypto transaction is essentially a transfer of value by means of a specific crypto coin/token. The details of this transaction are recorded on blockchain blocks and broadcast to the whole cryptocurrency network, following appropriate validation.
The implementation of this process is vital for providing the trust required for any cryptocurrency transaction, due to its decentralized nature.
There are several steps a transaction must go through until it is added to the blockchain and be considered fully validated.
- Authentication: Blockchain was specifically designed for operation without any central authority (bank, regulator, etc.). Nevertheless, transactions still have to be authenticated. This is usually achieved by using cryptographic keys that identify users and provide access to their account (digital “wallets”).
Every user has his own private key (known only to him), as well as a public key (which is public). Both of them together create the secure digital identity necessary to authenticate the user, enabling him to ‘unlock’ the transaction.
- Authorisation – Once the transaction has been agreed upon between users, it must be authorised before it is added to a block.
On a public blockchain, the method by which a decision is made to add a transaction to the chain is through consensus. This means it’s done through majority rule; a majority of nodes (51% minimum) must approve the validity of the transaction. Once a transaction has accumulated sufficient confirmations from network nodes, it becomes almost irreversible (It can be reversed only – again – through a majority consensus to reverse the transaction).
- Validation – There are several kinds of consensus mechanisms in use for transaction confirmation on a blockchain network: “Proof of work”, “Proof of stake” and “Proof of burn”.
- Proof of work is the original method of transaction validation, implemented by Bitcoin’s founder – the mysterious Satoshi Nakamoto – as a way to process activities while dispensing with any third party. This method is still used by many other cryptocurrencies.
So how does this work?
This mechanism consists in solving difficult mathematical puzzles. The process is called “mining”. The mining becomes, by design, progressively more difficult so miners are rewarded by coins each time they solve the puzzle.
As cryptocurrencies became more popular, some disadvantages of the proof-of-work method surfaced:
- High energy consumption: the odds of solving the puzzles are about 1 in 5.9 trillion! The only way, even with the most advanced computers, is by trial and error. This requires enormous computing power – building mining pools and server farms – as well as a lot of electricity. (Only recently it was estimated that Bitcoin’s electricity consumption was above Argentina’s, the Netherlands’, and the United Arab Emirates’ – and getting closer to Norway’s).
- Vulnerability to 51% attacks: One mining entity could in principle be able to accumulate 51% of Bitcoin’s mining hashrate; this grants him/it the ability to disregard the rules, change blocks, double-spend and to block transactions.
- Centralization: The need to invest large resources in order to mine coins has created a de-facto “monopoly” in the system, since three or four mining pools control almost 50% of Bitcoin’s computational power.
- Proof of stake was developed in light of all this, in order to address some of the issues. It will be implemented in Diem (like on First’s site), and recently Ethereum announced it is moving in that direction.
So how does this work?
Basically, each user locks a certain amount of funds on his node; this is his stake. Once the stake is locked in place he participates in a contest: which node will be chosen to “forge” the next block (stakers forge blocks, they do not mine them). Winning this contest depends on several factors:
- How much funds have been staked?
- For how long have they been staked for?
- Random algorithm (in order to prevent any single entity gaining a monopoly over forging).
The theory behind this method is that the more you stake, the greater your motivation to keep the blockchain secure; the penalty being that if you try to subvert the system you lose the funds you’ve staked.
- “Proof of burn” is the newest method, invented to try and eliminate several drawbacks of the earlier methods.
So how does this work?
Proof of Burn (PoB) is a lot like the Proof of Work algorithm, but without the energy consumption. The validation process of PoB-based networks does not depend on mining hardware. This method requires cryptocurrencies to be “burned” as a way of investing resources in the blockchain. Miners invest in virtual mining rigs.
By performing coin burns, users demonstrate their commitment to the network, thus obtaining the right to “mine” and validate transactions. Since the burning of coins is virtual, the more coins a user burns, the more mining power he has, and the higher the chances to be chosen as the next block validator.
We’ve discussed what makes digital currencies possible, where they come from, and how they’re exchanged. Now let’s talk about how they’re stored…
When digital currencies are mined on their blockchains or transferred between users, they must be stored until their new owner is ready to use them. That’s where digital currency wallets come into play.
Wallets are simply pieces of software capable of housing digital currencies securely for an indefinite period of time.
All digital currency wallets have a public key and at least one private key.
The simplest way to understand the public key is to think of it like an anonymous address. When you send or receive digital currency, that address is recorded on the public ledger for your transaction. Everyone can see it, but it contains none of your personally identifiable information. It simply documents your wallet’s location on the blockchain network.
The private key, on the other hand, is seen by nobody but the wallet’s owner. It contains the cryptographic information needed to authorize transfers out of the wallet, and it should never be shared. Private keys are often secured through encryption and backed up in hard copy on paper.