How Do Cryptocurrencies Work?
How Do Cryptocurrencies Work?
Cryptocurrencies are a form of digital money that runs on a completely new monetary system, which is decentralised and peer-to-peer. Essentially, this means that cryptocurrencies eliminate trusted third parties, such as banks or governments. For such a network to work effectively, it needs to be foolproof, with every transaction done in a transparent and verifiable manner. This network is what is basically called the blockchain, and at the centre of the blockchain technology, is the distributed ledger.
By definition, a distributed ledger is a held database that can be updated independently by any participant who is part of a larger network. This is in contrast to other ledgers that only have a single authority that counter checks and updates everything. To perform a transaction on the distributable ledger, you will need a cryptocurrency wallet. This is, basically, like a normal wallet, but now digital and encrypted.
A crypto wallet will have a public key and private key, which serves as your digital identity on the platform. Your public key is how you are identified by anyone on the trading platform, and it is what you can share with anyone who needs to send you crypto funds. But for you to perform any transactions on the distributable ledger (like sending or accessing your funds), you will need your private key(s).
It is these public and private keys that have seen cryptocurrencies labelled as being pseudonymous. A distributable ledger is open for all participants to see, and anyone can possibly see transactions between different wallet addresses. While your public and private keys give you a digital identity, they are not necessarily tied to your real-life identity. You are not entirely anonymous, because the distributed ledger is open source, but rather pseudonymous, because no one can easily determine your personal identity by watching the transaction flow.
With the absence of a trusted third party, distributed ledgers are based on a consensus between the transacting parties. When a consensus is reached, the public distributed ledger is updated. But distributed ledgers were also designed to be immutable or unchangeable. To achieve this immutability, there has to be a verifying system. This is where cryptocurrency mining comes in.
On the distributed ledger, a collection of transactions is usually arranged into a ‘block’. Blocks are usually heavily encrypted, hence the word cryptocurrency, and they are turned into complex mathematical puzzles. Whoever solves the puzzle, gets to append the block into the blockchain. The processing of solving those puzzles is what is known as mining. Miners compete to solve the puzzles, and whoever wins, they get rewarded with new coins of the underlying blockchain network.
For example, if it is the Bitcoin blockchain, a miner will get rewarded in Bitcoins. This is, by design, how new cryptocurrency coins are created. Mining thus controls the speed at which coins are created (or the supply). By theory, with more supply, there is the threat of devaluation of the underlying coins. To prevent this, the puzzles are designed to get harder when more blocks are built.
But there is also another reason why mining is important. Mining ensures the accuracy and fidelity of transactions, which is imperative because once a transaction is added on the distributed ledger, it cannot be altered. This introduces the Proof of Work concept, which as the name suggests, is a system of validating work and proving that it is indeed correct. Miners commit a lot of computational resources to find the answers to the mathematical puzzles. With Proof of Work cryptocurrencies, the puzzles are designed to be hard to solve, but very easy to verify or prove that it is correct. It is this Proof of Work that validates a cryptocurrency coin or gives it value.
Despite the foolproof nature of the Proof of Work system, there are some limitations. You will require hardware with huge computational power to increasingly solve harder puzzles, and this makes the process of mining expensive. This will also likely mean that only big players can be incentivised to do mining, which defeats the entire decentralisation aspect of cryptocurrencies.
The Final Word
So, in summary, cryptocurrencies are basically digital coins that run on a distributed ledger system. They are produced by miners who have specialized hardware designed to solve mathematical puzzles before a transaction is verified and added on the distributed ledger where it now becomes immutable. The idea of work giving value to a cryptocurrency coin is what is known as the Proof of Work system.
How Do Cryptocurrencies Work FAQ
- What is the disadvantage of cryptocurrency?
We always hear about the benefits of cryptocurrencies, but are there any downsides to this new form of money? As with anything, yes there are some negatives. One of the most drastic for everyday use is the volatility that cryptocurrencies exhibit. While it’s a great trait for traders, it’s not so wonderful for people who don’t want to live in fear that their life savings could drop in value by 30% or more in a month. Another problem is that many merchants still don’t accept cryptocurrencies. That’s slowly changing, but still remains a concern in 2020.
- How can you make money with cryptocurrency?
In addition to trading on cryptocurrencies there are a number of ways to make money with these unique new assets. One related way is through investing. Buying at lower prices and holding on as the price of the cryptocurrency rises. It is also possible to do something called staking, which pays out small amounts of cryptocurrency just like interest or dividend payments. Others also use computers to mine cryptocurrency, and this is how all of the Bitcoin is created. One further way is through airdrops or forks. In an airdrop the cryptocurrency development team gives away coins. A fork creates a new cryptocurrency and the holders of the old cryptocurrency are also given an equal amount of the new cryptocurrency.
- How are cryptocurrencies used?
There are many uses for cryptocurrencies depending on why they were created. A large number are considered to be transactional currencies, and are meant to be used just like the fiat currency you’re used to – buying goods and services. Others are designed as a medium of exchange for digital information or data. Still others, like Bitcoin, have been designed as a store of value like gold. Still other cryptocurrencies are being developed as a way to run the Internet of Things, making micropayments within systems in order to facilitate communication and cooperation between machines.