The Cryptocurrency Basics
To understand how cryptocurrency works, you’ll need to learn a few basic concepts. Specifically:
Public Ledgers: All confirmed transactions from the start of a cryptocurrency’s creation are stored in a public ledger. The identities of the coin owners are encrypted, and the system uses other cryptographic techniques to ensure the legitimacy of record keeping. The ledger ensures that corresponding “digital wallets” can calculate an accurate spendable balance. Also, new transactions can be checked to ensure that each transaction uses only coins currently owned by the spender. Bitcoin calls this public ledger a “transaction block chain.”
Transactions: A transfer of funds between two digital wallets is called a transaction. That transaction gets submitted to a public ledger and awaits confirmation. Wallets use an encrypted electronic signature when a transaction is made. The signature is an encrypted piece of data called a cryptographic signature and it provides a mathematical proof that the transaction came from the owner of the wallet. The confirmation process takes a bit of time (ten minutes for bitcoin) while “miners” mine. Mining confirms the transactions and adds them to the public ledger.
Mining: Mining is the process of confirming transactions and adding them to a public ledger. To add a transaction to the ledger, the “miner” must solve an increasingly-complex computational problem (like a mathematical puzzle). Mining is open source so that anyone can confirm the transaction. The first “miner” to solve the puzzle adds a “block” of transactions to the ledger. The way in which transactions, blocks, and the public blockchain ledger work together ensure that no one individual can easily add or change a block at will. Once a block is added to the ledger, all correlating transactions are permanent, and they add a small transaction fee to the miner’s wallet (along with newly created coins). The mining process is what gives value to the coins and is known as a proof-of-work system.
The Anatomy of Cryptocurrency
Although there can be exceptions to the rule, there are some factors (beyond the basics above) that make cryptocurrency so different from the financial systems of the past:
Adaptive Scaling: Adaptive scaling means that cryptocurrencies are built with measures to ensure that they will work well in both large and small scales.
Adaptive Scaling Example: Bitcoin is programmed to allow for one transaction block to be mined approximately every ten minutes. The algorithm adjusts after every 2016 blocks (theoretically, that’s every two weeks) to get easier or harder based on how long it took for those 2016 blocks to be mined. So if it only took 13 days for the network to mine 2016 blocks, that means it’s too easy to mine, so the difficulty increases. However, if it takes 15 days for the network to mine 2016 blocks, that shows that it’s too hard to mind, so the difficulty decreases.
Other measures are included in digital coins to allow for adaptive scaling including limiting the supply over time (to create scarcity) and reducing the reward for mining as more total coins are mined.
Cryptographic: Cryptocurrency uses a system of cryptography (AKA encryption) to control the creation of coins and to verify transactions.
Decentralized: Most currencies in circulation are controlled by a centralized government so their creation can be regulated by a third party. Cryptocurrency’s creation and transactions are open source, controlled by code, and rely on “peer-to-peer” networks. There is no single entity that can affect the currency.
Digital: Traditional forms of currency are defined by a physical object (USD existing as paper money and in its early years being backed by gold for example), but cryptocurrency is all digital. Digital coins are stored in digital wallets and transferred digitally to other peoples’ digital wallets. No physical object ever exists.
Open Source: Cryptocurrencies are typically open source. That means that developers can create APIs without paying a fee and anyone can use or join the network.
Proof-of-work: Most cryptocurrencies use a proof-of-work system. A proof-of-work scheme uses a hard-to-compute but easy-to-verify computational puzzle to limit exploitation of cryptocurrency mining. Essentially, it’s similar to a difficult to solve “captcha” that requires lots of computing power. NOTE: Other systems like proof-of-work (such as proof-of-stake) are also used.
Pseudonymity: Owners of cryptocurrency keep their digital coins in an encrypted digital wallet. A coin-holder’s identification is stored in an encrypted address that they have control over – it is not attached to a person’s identity. The connection between you and your coins is pseudonymous rather than anonymous as ledgers are open to the public (and thus, the ledgers could be used to glean information about groups of individuals in the network).
Value: For something to be an effective currency, it has to have value. The US dollar used to represent actual gold. The gold was scarce and required work to mine and refine, so the scarcity and work gave the gold value. This, in turn, gave the US dollar value.
Cryptocurrency works similarly regarding value. In cryptocurrency, “coins” (which are nothing more than publicly agreed on records of ownership) are generated or produced by “miners.” These miners are people who run programs on specialized hardware made specifically to solve proof-of-work puzzles. The work behind mining coins gives them value, while the scarcity of coins and demand for them causes their value to fluctuate. The idea of work giving value to currency is called a “proof-of-work” system. The other method for validating coins is called proof-of-stake. Value is also created when transactions are added to public ledgers as creating a verified “transaction block” takes work as well. Further, value comes from factors such as utility and supply and demand.