What Are Cryptocurrencies and How Do They Work?
By now, you’ve probably at least heard the term “cryptocurrency.” But to the uninitiated, cryptocurrencies are a confusing subject, because they’re much different than other payment methods.
Like any technology advancement, cryptocurrencies and how they work will eventually become common knowledge to everyday consumers. In that time frame between now and when that happens, there’s the opportunity for those with a greater understanding of cryptocurrencies to get on board with a new technology and potentially make some money from their knowledge.
The word “cryptocurrency” gives you an idea of how these currencies work – they’re digitally encrypted money. They use open source software that anyone with the money can obtain to verify transactions, meaning cryptocurrencies are decentralized and aren’t run by a big bank or government. Transactions take place entirely online, and transactions go on the blockchain, a public ledger.
This guide will cover the ins and outs of cryptocurrencies. We’ll start with a look at the cryptocurrency timeline.
A Brief Cryptocurrency History
While there are over 1,000 cryptocurrencies, the very first is probably the one you’ve heard about the most – Bitcoin. Its official release came January 3, 2009. There were attempts at other decentralized cryptocurrencies prior to Bitcoin, but it was the one that became successful.
After Bitcoin came many new cryptocurrencies with various degrees of success. The name for these other cryptocurrencies is alt-coins, short for alternative coins. Of these, Ethereum is the biggest.
The number of cryptocurrencies has been growing rapidly, and it was at 1,658 as of March 2018. Considering dozens of cryptocurrencies are often created within a week, that number will likely keep going up. In terms of market capitalization, cryptocurrencies as a whole have surpassed $100 billion.
The Role of Cypherpunks
Cypherpunks, a term for the people who encrypt what they do when using the internet to keep their activities private, have been instrumental in many technological developments, including cryptocurrencies.
If you’re interested in some of the most notable cypherpunks and their creations, there are:
- Julian Assange of Wikileaks
- Phil Zimmerman of PGP Encryption
- Nick Szabo of BitGold
- Adam Beck of HashCash
- John Gilmore of Bootstrap Protocol
- Tim C. May of Crypto Anarchy and Virtual Communities
- Hal Finney of RPOW
- David Chaum of DigiCash
- Wei Dai of B Money
The creator of Bitcoin is only known by the alias of Satoshi Nakamoto (a satoshi is also the term for the smallest fraction 1 bitcoin can currently break down into, equating to one hundredth of a millionth or 0.00000001 bitcoin).
He has kept his identity private, and it’s possible that Nakamoto isn’t even one person but multiple people working together.
To know cryptocurrencies, you must understand several key concepts, which are explained here.
When information or data is encrypted, it’s turned into a code before transmission, ensuring it stays private. Although encrypted information often has one key that both encrypts and decrypts it, that isn’t the case with cryptocurrencies, as there are separate keys for each process.
These keys are connected to each other mathematically.
The encryption key is public, and that’s the key for a person’s Bitcoin wallet. Any person who has the key can send data or bitcoins to the wallet.
Whatever is sent will be encrypted and must be decrypted through a private key.
When something is centralized, there’s one party or group that owns and controls it. Bitcoin and other cryptocurrencies are protocols, like the internet, and there isn’t a specific entity in control of them.
Cryptocurrencies use mathematical rules to function, and all participants in those cryptocurrencies agree to the rules. Transaction verification occurs through the work of a network of computers that anyone can become a part of, if they wish to perform Bitcoin mining.
The system cryptocurrencies use is distributed across a network of computers that are all in contact with each other and transmitting messages back and forth.
Open Source Code
When a software has open source code, anyone can use, share and modify it. This kind of software technically has many people who create and build it.
Cryptocurrencies fall into this category, as anyone can join on or use them and developers can build application program interfaces (APIs) with no fee required.
The Transaction Process
Transactions with cryptocurrencies are fast and efficient.
Let’s say you want to send someone bitcoins. Your Bitcoin wallet would create the data structure representing the transaction, encrypting it with an electronic signature.
Your transaction then gets transmitted to the network on a public ledger. The nodes currently running on the network will validate the transaction using mathematical proofs.
As long as a transaction can be validated, the node puts that transaction in the block it’s mining.
The blockchain is a public ledger. This decentralized, distributed database is where the transaction records go. Everything is recorded publicly and in chronological order.
As more blocks go on the blockchain, it becomes larger and larger.
Whenever a new node joins the Bitcoin network, it automatically downloads a current copy of the blockchain. On the blockchain are wallet addresses and the amount each wallet has, dating all the way back to the genesis block and ending at the most recent block.
A node is a connection or intersection point in a network. With Bitcoin, nodes are the computers that are part of the network, operate using the Bitcoin protocol and communicate with each other to validate transactions and blocks.
The nodes are what makes the Bitcoin magic happen, and without them, Bitcoin wouldn’t work. They are all validators of Bitcoin transactions and blocks.
When a node receives transaction data, it must check every part of the transaction and cross-check it with the current copy of the public ledger that the node has, ensuring that funds won’t be spent twice.
When an incorrect transaction gets sent to a node, the node rejects the transaction and ceases communication with the sender.
One question people often have is what stops a node from cheating the system. Any node that attempts to spread inaccurate information will end up banned and disconnected, unable to communicate with other nodes anymore. There is no element of trust from node to node.
When a node decides a transaction is valid, then a miner will receive it. Once the miner returns the block, the node makes the call on whether that transaction is valid.
Although miners play an important role, the nodes are in charge of validity of the consensus rules, and they’re the ones preventing the spread of any misinformation.
This is the way that transactions become verified and part of the blockchain. In addition, it’s through mining that new bitcoins get released to the world. Technically, cryptocurrency mining is something that you only need a computer and internet access to do.
But it has been years since anyone could get much mining down that way. Those who are really interested in mining must purchase machines dedicated solely to that purpose now.
How mining works is that recent transactions go into blocks, and miners attempt to figure out a mathematical puzzle that’s extremely difficult to compute. There’s a reward for whichever computer or cloud of computers gets the correct answer first.
The winner adds the blockchain’s next block and earns the reward, which they get because they’ve performed an important role in the cryptocurrency system.
The block reward is the number of bitcoin that are released to the winner after a mined block. The presence of a reward encourages cryptocurrency mining, as miners have something to gain for their efforts.
While there is a set block reward amount, this gets cut in half after every 210,000 blocks have been added, and this generally takes about four years.
How quickly new blocks are added doesn’t change much, because the difficulty of the puzzles is self-adjusting based on the computational power of the miners.
As devices get more powerful, puzzles become more difficult, ensuring that block delivery occurs at the same rate.
Those concepts may be a lot to take in, but once you understand them, you understand what makes cryptocurrencies go.
Cryptocurrencies are the currencies of the future, and it makes sense to get some of your own now. They offer fast transactions and total privacy, and their usefulness is why they’ve seen their value skyrocket so quickly.
Fortunately for buyers, the process of purchasing cryptocurrency has become far simpler and more user-friendly. If you’re ready to buy in, check out the best Bitcoin exchanges, which lists all the most reputable and highest quality exchanges (as of this writing – June 2018).
Most of those exchanges also offer other cryptocurrencies, in case you’d rather give Ethereum, Litecoin or something else a try.