Cryptocurrency is an encrypted, decentralized digital currency transferred between peers and confirmed in a public ledger via a process known as mining.
Below, we take a simplified look at how cryptocurrencies like bitcoin work. First, letโs review the basics and essentials of cryptocurrency, and then we will do an overview of the other properties that have made cryptocurrency what it is today.
๐ง๐๐ฃ:If the page below feels overwhelming, please see: โhow does cryptocurrency work (for beginners).โ Meanwhile, if you are mainly interested in trading, investing in, or using cryptocurrency, see โhow to trade cryptocurrency (for beginners).โ This page provides an overview of the mechanics behind cryptocurrency.
๐ง๐ต๐ฒ ๐๐ฟ๐๐ฝ๐๐ผ๐ฐ๐๐ฟ๐ฟ๐ฒ๐ป๐ฐ๐ ๐๐ฎ๐๐ถ๐ฐ๐
To understand how cryptocurrency works, youโll need to learn a few basic concepts. Specifically:
๐๐ฎ๐๐ฅ๐ข๐ ๐๐๐๐ ๐๐ซ๐ฌ: All confirmed transactions from the start of a cryptocurrencyโs 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 โdigital walletsโ 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 โtransaction block chain.โ
๐๐ซ๐๐ง๐ฌ๐๐๐ญ๐ข๐จ๐ง๐ฌ:A transfer of funds between two digital wallets is called a transaction. That transaction gets submitted to a public ledger and awaits confirmation. When a transaction is made, wallets use an encrypted electronic signature (an encrypted piece of data called a cryptographic signature) to provide a mathematical proof that the transaction is coming from the owner of the wallet. The confirmation process takes a bit of time (ten minutes for bitcoin) while โminersโ mine. Mining confirms the transactions and adds them to the public ledger.
๐๐ข๐ง๐ข๐ง๐ : Quite simply, mining is the process of confirming transactions and adding them to a public ledger. To add a transaction to the ledger, the โminerโ must solve an increasingly-complex computational problem (like a mathematical puzzle). Mining is open source so that anyone can confirm the transaction. The first โminerโ to solve the puzzle adds a โblockโ 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 minerโs 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.
๐ง๐ต๐ฒ ๐๐ป๐ฎ๐๐ผ๐บ๐ ๐ผ๐ณ ๐๐ฟ๐๐ฝ๐๐ผ๐ฐ๐๐ฟ๐ฟ๐ฒ๐ป๐ฐ๐
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:
๐๐๐๐ฉ๐ญ๐ข๐ฏ๐ ๐๐๐๐ฅ๐ข๐ง๐ : Adaptive scaling means that cryptocurrencies are built with measures to ensure that they will work well in both large and small scales.
๐๐๐๐ฉ๐ญ๐ข๐ฏ๐ ๐๐๐๐ฅ๐ข๐ง๐ ๐๐ฑ๐๐ฆ๐ฉ๐ฅ๐:Bitcoin is programmed to allow for one transaction block to be mined approximately every ten minutes. The algorithm adjusts after every 2016 blocks (theoretically, thatโs 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 itโs too easy to mine, so the difficulty increases. However, if it takes 15 days for the network to mine 2016 blocks, that shows that itโs 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.
๐๐ซ๐ฒ๐ฉ๐ญ๐จ๐ ๐ซ๐๐ฉ๐ก๐ข๐: 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. Cryptocurrencyโs creation and transactions are open source, controlled by code, and rely on โpeer-to-peerโ networks. There is no single entity that can affect the currency.
๐๐ข๐ ๐ข๐ญ๐๐ฅ: 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 peoplesโ digital wallets. No physical object ever exists.
๐๐ฉ๐๐ง ๐๐จ๐ฎ๐ซ๐๐: Cryptocurrencies are typically open source. That means that developers can create APIs without paying a fee and anyone can use or join the network.
๐๐ซ๐จ๐จ๐-๐จ๐-๐ฐ๐จ๐ซ๐ค: 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, itโs similar to a difficult to solve โcaptchaโ that requires lots of computing power. NOTE: Other systems like proof-of-work (such as proof-of-stake) are also used.
๐๐ฌ๐๐ฎ๐๐จ๐ง๐ฒ๐ฆ๐ข๐ญ๐ฒ:Owners of cryptocurrency keep their digital coins in an encrypted digital wallet. A coin-holderโs identification is stored in an encrypted address that they have control over โ it is not attached to a personโs 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).
๐๐๐ฅ๐ฎ๐: 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, โcoinsโ (which are nothing more than publicly agreed on records of ownership) are generated or produced by โminers.โ 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 โproof-of-workโ 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 โtransaction blockโ takes work as well. Further, value comes from factors such as utility and supply and demand.
๐๐ฒ๐ฎ๐ฟ๐ป๐ถ๐ป๐ด ๐ ๐ผ๐ฟ๐ฒ ๐ฎ๐ฏ๐ผ๐๐ ๐๐ผ๐ ๐๐ฟ๐๐ฝ๐๐ผ๐ฐ๐๐ฟ๐ฟ๐ฒ๐ป๐ฐ๐ ๐ช๐ผ๐ฟ๐ธ๐
If at this point, you feel a little bit confused, ๐ฑ๐ผ๐ปโ๐ ๐๐ผ๐ฟ๐ฟ๐ ๐ฎ๐ป๐ฑ ๐ฑ๐ผ๐ปโ๐ ๐ด๐ถ๐๐ฒ ๐๐ฝ.Understanding the concepts that are fundamental to cryptocurrency is a challenge. One explanation works for some people, and a different explanation works of others. We all learn in different ways.
The trick with cryptocurrency is not getting worried if you donโt understand it at first โ each new video, explanation, or article that you learn from will make your understanding of cryptocurrency clearer until, eventually, it clicks.
To learn more, visit some of the other, more technical pages on our site to dive deeper into the inner-workings of cryptocurrency. You can also watch informational videos about the how cryptocurrency works such as the one below.
๐๐จ๐ฎ๐ซ๐๐: https://cryptocurrencyfacts.com/how-does-cryptocurrency-work-2/