February 13, 2019

How Do Cryptocurrencies Work? Cryptocurrency FAQ

How Do Cryptocurrencies Work? Cryptocurrency FAQ

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.

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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 counterchecks 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 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).

Pseudonymous

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.

Mining

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.

Transactions

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.

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