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How Do Cryptocurrencies Work? A Comprehensive Guide

December 20, 2021

How Do Cryptocurrencies Work? A Comprehensive Guide

Cryptocurrencies have made a significant impact on the world of finance over the past decade. The bull run that took place during the fourth quarter of 2017 essentially introduced this new and interesting technology to the world. 

However, cryptocurrencies didn’t reach mainstream status until mid-2020. The skyrocketing popularity of cryptocurrencies was primarily driven by the public’s fear of inflation and the growth of the decentralized finance (DeFi) sector. Over the past year alone, Bitcoin has appreciated over 300%, reaching an all-time high of $64,000 in April 2020.

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Several altcoins have also managed to hit their all-time highs shortly after. This phenomenon eventually resulted in the total cryptocurrency market capitalization rising to a value of over $2.5 trillion by the end of Q1, 2021.      

All of these figures make us come to only one possible conclusion – cryptocurrencies are here to stay. When the global financial markets struggled during the pandemic and the US dollar value rapidly depreciated, cryptocurrencies managed to thrive. Do you have a cryptocurrency portfolio? Or, are you planning to invest soon? 

If the answer to either of these questions is yes, you have to learn at least the basics of how cryptocurrencies work. Having a fair understanding of the ecosystem will help you realize their potential and how decentralization improves traditional financial systems. So, let's get started.   

The Inner Workings of a Cryptocurrency

Cryptocurrencies would not exist if not for a decentralized ledger technology called “blockchain.” Almost every single cryptocurrency today is built on top of a blockchain. We can consider blockchain as a digital transaction ledger. This particular ledger has multiple copies and is distributed over a vast network of computers, also known as nodes. 

Every computer in this network has a copy of the ledger, which is automatically and simultaneously updated. The decentralized computer network enables the blockchain to authenticate transactions that occur in the network. All the transactions that occur in the network are permanently recorded on the blockchain. These transactions are immutable meaning they can never be deleted or modified.

Any transaction on the blockchain network must be verified by a consensus of nodes before the transaction is successfully processed. Once a specific number of transactions are authenticated, they are grouped into a block. Each block has an identifier, also known as a hash value. 

The hash values are automatically generated within the blockchain. Since each block is connected to its preceding block, changing or tampering with transactions in the most recent block will alter the hash value of all the previous blocks. This makes it impossible for anyone to successfully alter or modify transactions in a blockchain.     

Additionally, since the ledger is completely transparent and public, anyone with an internet connection can see the transactions that have been processed. For instance, you can visit the blockchain explorer to see every single transaction that took place on the Bitcoin network. This qualifies the transparency aspect of the blockchain, which is never the case with centralized financial systems. 

Cryptocurrencies - Simplified

If all this sounds a bit confusing, let’s illustrate how cryptocurrencies work using a simplified example. Imagine playing a card game with your family and friends, but none of you have any money on hand. So, of the 15 people playing the game, five volunteers decide to note down the details related to the bets, such as who's betting, for how much, and who won. This means there will be five different records of the game as no one trusts each other. 

At the end of every round, we can compare the records and see if they are in sync. If they are not, that indicates some malicious entry, and it can be caught immediately. After recording certain entries, you might fill up your page and decide to write on a new page. Each of these pages can be considered a block. A set of these pages where the transactions are permanently recorded is none other than a blockchain. The five of the volunteers who decided to note down the transactions are nodes. 

Now let’s connect this example to the Bitcoin network.

Let’s imagine that the Bitcoin network is a huge table with millions of people playing cards. Some send money, some receive it, and many are keeping track of the transactions. When you wish to send Bitcoin to someone, you are essentially announcing that transaction to everyone at the table (in the network). With this, the validators can update their ledgers. While announcing a transaction, you will have to mention three things to the network:

  1. Your Bitcoin Address (Public Key) 

  2. The Bitcoin Address of the receiver

  3. The amount of BTC you want to send

What about Security? Cryptography is the Answer!

If all it takes is a couple of addresses to transact cryptocurrencies successfully, doesn’t that sound like a huge security problem? This problem is solved by cryptography. Every transaction on any blockchain is secured cryptographically. 

More so, the security is further enhanced by the anonymity involved in these transactions, thanks to the public and private keys associated with cryptocurrency wallets. These keys are alphanumeric, which means that your identity is not linked to your wallet. 

When you sign-up or create a wallet on the Bitcoin network, your information is linked to two unique keys: one public, and one private key. The private key must always be kept confidential as it is used to authenticate transactions. 

As an example, if Tom wants to transfer 1 BTC to Harry, he announces that to the network. Tom will then have to approve that announcement by signing it with his private key (which is only visible to Tom and is never made public). Once Tom executes the transaction, network validators check the transaction to ensure that Tom has sufficient BTC in his wallet to send to Harry, as well as to pay the network fee. After the transaction has been verified, it is added to the blockchain alongside other transactions that it was grouped with.

Conclusion

Cryptocurrencies are an innovative invention created to bring decentralization to the financial sector. Its native characteristics make it appealing both to tech enthusiasts and investors. However, in order not to lose your savings by investing in crypto, you have to learn the inner workings of the ecosystem.

Do you think that this innovative technology could ever replace traditional financial systems? Let us know in the comments below. Cheers!

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