Let’s try to get the most simplistic view of cryptocurrency first and foremost. It’s a decentralized digital currency produced and managed following advanced cryptographic principles, which is transferable among a network of peers, where every transaction is recorded and confirmed almost instantly over a public ledger accessible to everyone on a cryptocurrency network.
For a better of understanding of how cryptocurrency works, you’ll have to familiarize yourself with a few basic concepts, the most important of which include:
Public ledgers and blockchains: In a cryptocurrency network, all legit transactions right from the time of its creation, are stored and maintained in a public ledger. Cryptographic techniques are not only used to cover the identities of the coin owners, but also to ensure and establish the legitimacy of the whole record-keeping process. These ledgers enable the corresponding “digital wallets” to determine and calculate the exact spendable balance of any member of the network. This also makes sure that a person only uses the coins he/she currently owns. All transactions taking place over the network are collected and stored as blocks of information, where each new block can be added as an extension to the already existing chain of blocks, the whole concept being referred commonly as the “blockchains”.
Transactions: Any instance involving transfer of funds between any two digital wallets in a cryptocurrency network is termed as a transaction. Such a transaction needs submission to a public ledger where it has to undergo confirmation. For every transaction, an encrypted electronic signature (labeled commonly as a cryptographic signature) is used by the wallets, which serves as a mathematical proof of the legitimacy of the owner of the wallet. This whole process takes a bit of time, ranging anywhere between 10 minutes to around an hour or so for different cryptocurrencies. This might seem a lot, but when compared to the time required for confirmation of a transaction in conventional banking systems, which take between 3 to 5 days, it’s almost negligible.
Mining: The process used by a cryptocurrency network for confirmation of transactions, leading to their addition into a public ledger, is simply referred as mining, and those who do so are referred as the “miners”. To successfully confirm and add a transaction to the ledger, a miner is required to solve a highly complex computational problem (you might consider it as a mathematical puzzle). Since mining is open source in nature, anyone on the network can compete to confirm a transaction. The miner who is able to solve the puzzle prior to others competing for the same job, is eligible to add a “block” of information constituted by a specific number of transactions, as an extension of the already existing chain of blocks. The truth is that “confirmation” is regarded as the single most critical concept in cryptocurrencies, without which cryptocurrencies might not be able to function at all. As long as a transaction gets confirmed in a cryptocurrency network, it remains pending and prone to some sort of forgery. However, as soon as a transaction gets confirmed, it is set in stone, no longer prone to forgery or exploitation, unable to get reversed under any circumstances. Transactions of a cryptocurrency network can only be confirmed by miners, a job solely designated for them. They collect transactions across the network, stamp them for legitimacy and disperse them throughout the network. When a miner confirms a transaction, every node on the network is bound to update it to the record of database they have, treating it as a part of the ever-growing blockchain. This mechanism, in which transactions, blocks as well as the public blockchain ledger work in unison, makes sure that neither an individual nor a group can meddle with the flow of things or the information contained within the blocks. Following all the procedures, when a block is finally added as part of the blockchain ledger, information recorded and passed on through it becomes an immutable part of the blockchain, nothing of which can be reverted back by any means. For their services, a miner who succeeds in updating a block of information to the ledger, is rewarded by the system in form of coins (a predetermined amount set by the network) of that particular cryptocurrency being transferred to their accounts or electronic wallets. It is this mining process, which inculcates value to the coins, also referred commonly as “proof-of-work” system.
Salient Features of Cryptocurrency
With perhaps a few exceptions, generally a host of factors (in addition to the basics stated above) make cryptocurrency different from conventional financial systems, such as:
Decentralization: Almost in all fiat currency systems, circulation of currency is controlled either by a centralized government or some sort of other centralized regulatory authority. In other words, the proceedings are being regulated and managed by a third party. When it comes to cryptocurrency, however, the creation of new currency units and transactions remains open source, not being controlled by any type of third party but by code, relying on a “peer-to-peer” network. So, there’s no single centralized entity or authority that can affect the creation or circulation of a cryptocurrency.
Cryptographic: A cryptocurrency relies on principles of cryptography (i.e. encryption) to manage the creation of new coins as well as the verification of all transactions.
Digitalized: Traditional currencies have to be defined and equalized against a physical object (gold reserves equaling the total value of USD in circulation, for example), but there’s nothing physical about a cryptocurrency, everything is digital. Digital wallets are used to store digitally created coins and any movement of currency is from one digital wallet to another over a cryptocurrency network.
Open Source: Being open source in nature is yet another distinguishing feature of cryptocurrencies. This is what lures so many people to jump into the realm of cryptocurrency, the developers from around the world are allowed to create APIs without having to pay any fee for it and anyone from almost every part of the world can join a cryptocurrency network.
Proof-of-work: Proof-of-work is used by almost all cryptocurrencies, which mostly comprises of computational puzzles that are hard to compute but not so hard to verify, thus limiting the probability of exploitation in cryptocurrency mining. However, solving these cryptographic problems requires some serious and dedicated computational power along with lots of time.
Pseudonymity: The digital coins owned by members of a cryptocurrency network are stored in encrypted digital wallets. All information about a coin-holder is stored by means of an encrypted address, which can be controlled only by them, but not attached to their identity. In fact, a person and the coins they own are linked to each other by a pseudonymous rather than anonymous connection, as the ledgers containing information about their transaction history are openly accessible to all members of the network.
Value: Anything cannot be deemed effective as a currency if it doesn’t have sufficient value. For example, US dollar is backed by actual gold equal to its value, which is quite a scarce commodity, requiring some hard work for mining and refining. This scarcity and hard work make gold a valuable commodity, which in turn, makes US dollar valuable. There’s a similar concept at work behind cryptocurrency. “Miners” generate or produce cryptocurrency coins (which are basically publically agreed upon ownership records of digital nature). Fact of the matter is that anyone on a cryptocurrency network willing to run specific programs on specialized hardware equipment designed especially for solving proof-of-work cryptographic puzzles, can choose to be a miner, owed to open source nature of cryptocurrency. All the effort and time required in mining process is what gives coins a certain value, while their scarcity and demand results in fluctuation in their value. This is what “proof-of-work” system is all about; the concept of work and time giving value to a cryptocurrency. There’s also an alternative method of validating cryptocurrency coins, known as “proof-of-stake” method.
Adaptive Scaling: This is a concept that pertains to making sure that cryptocurrencies are built around architecture capable of supporting seamless functionality on small as well as large scales. Let’s take an example of Bitcoin, the pioneer of cryptocurrencies, to better understand adaptive scaling. Bitcoin network is programmed to mine a block of transactions every ten minutes. After mining every 2016 blocks of information, the algorithm being used for this purpose adjusts itself (theoretically, two weeks are required for mining of 2016 blocks), getting harder or easier depending on actual time consumed in processing those 2016 blocks. Now, if 2016 blocks took only 13 days to be mined, it means they were too easy; so, the difficulty level of the algorithm is increased automatically. However, if the network took 15 days in mining 2016 blocks of information; the difficulty level decreases consequently, considering the fact that blocks were hard to mine. Certain other measures are also taken into consideration as a means of adaptive scaling, such as limiting the supply of coins overtime (thus creating scarcity) and lowering the reward on mining as the total number of coins mined continues to increase.
Future of cryptocurrency
Not only has cryptocurrency risen to global fame in a considerably short period of time, but fortune as well. Bitcoin, the very first of the modern cryptocurrencies, was launched for the first time in 2009 and ever since then; cryptocurrency has grown amazingly well, expanding to a total market cap of over $24 billion as pooled by about 100 of the top cryptocurrencies in circulation right now. This clearly reflects of the bright future it is capable of having in times to come. Moreover, blockchain technology, the underlying architecture of cryptocurrencies is also gaining some real traction, opening up countless new avenues of technological advancements, such as IoT (Internet of Things), decentralized cloud storage, digital assets and so much more.